Chapter 13

Transparency and Financial Reporting in Islamic Insurance

Elham Hassan and Andre Rohayem

13.1 INTRODUCTION

Awareness of Islamic insurance (also known as takaful, the Arabic word for “solidarity”) has been increasing in Muslim countries, and this has enhanced the acceptance by the public of Islamic insurance products, be they general or family products. This acceptance has resulted in the establishment of a number of Islamic insurance companies in the Middle East and Southeast Asia, in addition to those companies established in the 1970s and 1980s. Islamic insurance companies are also currently being established in European countries that have a significant Muslim community, such as the United Kingdom.

Islamic insurance companies face the same challenges as conventional insurers. The public and the markets are requesting greater transparency and better financial reporting. Transparency is required in order to better reflect the structure of the companies that are being established, as well as in the reporting of their performance and financial position. Transparency is also requested in connection with stakeholders' rights, including those of policyholders.

An increasing number of conventional insurers have adopted the International Financial Reporting Standards as their main reporting framework to stakeholders. This has helped make financial reporting, to a certain extent, comparable and relevant. However, Islamic insurers have different structures and face different risks which require a specific financial reporting framework.

As for any reporting framework, transparency is required to ensure that the ultimate objective of reporting is achieved, which consists of communicating information to all stakeholders about the financial position and performance of the company, as well as their underlying rights. Transparency in financial reporting is also needed in order to address the increasing concern of regulators and standard setters for insurance companies whether conventional or takaful.

This need for transparency led to the issuance by the Accounting and Auditing Organization for Islamic Financial Institutions of two financial accounting standards for Islamic insurance companies in 2000 and 2001. One of the objectives of these standards was to address the specificities of Islamic insurance companies, especially with respect to policyholders' rights in underwriting funds and the movements in these funds.

Although the AAOIFI standards improved the financial reporting of Islamic insurance, we believe that financial reporting standards applied by Islamic insurance should be improved and become more takaful-specific. In addition to improved accounting standards, greater transparency is required from Islamic insurers. This could be achieved through better corporate governance (see Chapter 4).

13.2 STAKEHOLDERS NEED TRANSPARENCY IN FINANCIAL REPORTING BY ISLAMIC INSURANCE COMPANIES

13.2.1 Transparency in Financial Reporting

There is an increasing demand from the markets for better and more transparent financial reporting. Corporations, including insurers, are under pressure to report relevant and useful financial data in a more transparent manner.

What does “transparency in financial reporting” mean?

There are many definitions of transparency in the context of financial reporting. In this chapter, it is defined as the voluntary disclosure of financial information that addresses best all the needs of a corporation's stakeholders.

This definition of transparency in financial reporting is based on the two following pillars:

13.2.1.1 Voluntary Financial Reporting

Current Market Practice.   A large majority of insurance companies comply with the compulsory financial reporting disclosures required by regulators and their local financial reporting framework. Those that do not comply with these requirements are indirectly penalized by their stakeholders, including the markets where they operate. Providing less than minimum financial reporting impacts negatively on the value of the shares of these companies in the stock markets.

Insurance companies often provide additional financial information as a result of the increasing demand expressed by their stakeholders. Such information would include, for example, embedded values in insurance contracts and key performance indicators not commonly disclosed by insurance companies. Islamic insurance companies established in the 1970s and 1980s in non-sophisticated financial markets were not subject to such market demands. Consequently, these companies did not voluntarily disclose financial information that is not required by regulatory and local reporting frameworks.

Stakeholders' entitlement to transparent financial reporting has mainly been preserved by the Shari'ah boards of Islamic insurance companies. However, the financial reporting of these companies demonstrates that, despite Shari'ah boards, these companies did not voluntarily disclose financial information in excess of the minimum regulatory and compulsory financial information.

The increasing awareness of Islamic insurance and reinsurance and the development and sophistication of the markets are resulting in an increasing demand for financial information. Even regulatory requirements are increasing and focusing more on stakeholders' needs (refer to the following section). This trend can be observed in Southeast Asia (Malaysia and Singapore) and, more recently, in the Middle East (Bahrain and Qatar).

Future Financial Reporting Trends.   The markets and the stakeholders in these countries are developing and are becoming more sophisticated. Stakeholders have access to better-quality financial information from more sophisticated markets and expect to obtain similar information from the takaful markets. These increasing expectations are putting more pressure on takaful companies to disclose voluntarily financial information that they would not otherwise have disclosed.

Takaful companies will no doubt be driven to disclose voluntarily financial information in excess of what is required by local financial reporting and regulatory frameworks. There will always be reluctance from takaful companies to disclose financial information that they believe could benefit their competitors. Moreover, takaful companies will also assess the cost attached to preparing such information and compare that cost to the benefits from disclosing it. Takaful companies are easily able to determine the cost of preparing this information. But the benefits from disclosing it will not necessarily be easily quantifiable, especially for companies that have not been used to disclosing financial information other than what was required by regulators and financial reporting frameworks.

As mentioned earlier, the AAOIFI responded to these increasing demands for better financial reporting that takes into account the specificities of takaful companies by issuing two standards on Islamic insurance companies (AAOIFI Standards 12 and 13), which will be examined in more detail later in this chapter. These standards set the basis for the financial reporting of takaful companies and specifically address the disclosure of policyholders' rights in accumulated funds.

Although takaful companies will be driven to disclose more financial information, the challenge for these companies lies in quality. Stakeholders will only reward companies that disclose relevant and useful financial information that addresses their needs.

13.2.1.2 Criteria for Sound Financial Reporting

Takaful companies will increase the quality of financial reporting if it results in benefits that exceed the underlying cost of providing it. There could only be benefits to takaful companies if there are benefits to stakeholders. Stakeholders will assess the financial reporting of takaful companies and will benefit from it if it is relevant and useful.

As previously mentioned, financial information is relevant when it takes into account the specificities of the company. Takaful companies are different from conventional insurance companies in many ways, including their philosophy, their structure, and policyholders' entitlements and rights. Financial reporting of takaful companies should take into account these specificities. AAOIFI standards address a significant number of these characteristics.

Stakeholders' satisfaction is maximized when financial reporting is relevant and also useful. As previously mentioned, financial reporting is useful when it is accessible to stakeholders in a timely manner, understandable, and comparable to that of other takaful companies.

Timeliness of Financial Reporting.   Timeliness of financial reporting is fundamental. Stakeholders do not value financial information unless it is available when they need it for their decision-making process. Robust financial reporting processes and a formal financial reporting communication plan are required to produce financial reporting in a timely manner according to stakeholders' expectations.

Understandability of Financial Reporting.   Financial reporting should be understandable. Stakeholders can use the information provided only if they understand it. Takaful companies' operations are complex and cannot be easily understood by stakeholders without a basic knowledge of Islamic insurance. One can expect analysts, brokers, and reinsurance companies to have the necessary knowledge to understand and analyze takaful companies' financial reporting. However, only a limited number of policyholders would be able to fully understand and analyze financial information issued by takaful companies. Although it is expected that not all stakeholders would understand such financial information, takaful companies have a duty to all stakeholders to make financial reporting as clear and as understandable as possible.

Comparability of Financial Reporting.   Financial reporting of takaful companies should also be comparable. Comparability of financial reporting is achieved when similar financial information is available for takaful companies with similar structures and operations. Comparability is achieved when takaful companies report financial information required by local and regulatory standards as well as additional financial information that is needed by stakeholders. Unless takaful companies are structurally different, one would expect the additional financial information reported by takaful companies to be comparable on the basis that the stakeholders of different takaful companies would have comparable needs, which would drive takaful companies to disclose comparable financial information. Regardless of whether the company's operator is remunerated through a wakalah or a mudarabah agreement, policyholders require financial information about policyholders' funds and surplus distributions. They also need information about the investment strategy governing their contributions and the return thereon.

However, the requirements of the stakeholders of takaful companies are not similar to those of conventional proprietary insurance companies. Takaful companies are different in their philosophy, their structure, and the products they sell. They do have some affinities with conventional mutual companies, but the latter are generally not well known in the countries where takaful companies have been established.

13.2.2 Specificities of Islamic Insurance Companies

A typical takaful undertaking consists of a two-tier structure that is a hybrid of a mutual and a commercial form of company. Unlike a conventional insurance company, a takaful company is typically a combination of: (a) a takaful operator which is a stock corporation with shareholders' funds; and (b) the policyholders' funds, including one or more risk or underwriting funds and, in life or family takaful, investment funds. Capital is provided by the shareholders, whereas policyholders' contributions accumulate in dedicated funds. These funds enable the settlement of benefits to the policyholders upon the occurrence of a certain insured event. However, underwriting surpluses may be allowed to accumulate in underwriting funds, thus providing a further layer of capital (see Chapter 2).

The peculiarity of takaful companies lies in this two-tier structure. The operator is remunerated for services rendered, ranging from the management of the operation to the management of the policyholders' funds for and on behalf of the policyholders. Depending on the model adopted by the company (for example, wakalah or mudarabah), the operator could share some of the risks with the policyholders or be remunerated on a lump sum basis without sharing the risks and rewards with the policyholders. (In principle, however, the operator is not exposed to underwriting risks.) Consequently, the operator's interest is not always aligned to that of the policyholders. In such a structure, it is fundamental that underwriting or risk funds belong to the policyholders and are dedicated to covering their benefits according to the various types of Islamic insurance products.

In conventional proprietary insurance, premiums paid by the policyholders accumulate in funds from which benefits and claims are settled. Surpluses of premiums earned over benefits paid and claims payable constitute profit and are transferred to shareholders' equity. The company's interests consist of maximizing such surpluses and, consequently, increasing shareholders' wealth. Unlike the treatment in conventional proprietary insurers, but somewhat like that in conventional mutual insurers, surpluses in takaful policyholders' funds are not transferred to the operator's shareholders' funds. The operator is remunerated for the management of underwriting and investment, and shares in the returns earned on the policyholders' assets in case of a mudarabah agreement for the management of the policyholders' funds.

Based on the above, the main specificities that make takaful companies different from conventional insurance companies are as follows:

13.2.3 Financial Reporting Needs of Stakeholders of Islamic Insurance Companies

The stakeholders of Islamic insurance companies are numerous and not different from those of conventional insurance companies. However, they have different financial reporting needs and requirements.

Stakeholders of Insurance Companies. The stakeholders of Islamic insurance companies are the following:

• policyholders (also referred to as “participants”);
• shareholders (of the company's operator);
• Shari'ah supervisors;
• regulators; and
• other stakeholders.

Stakeholders of Islamic insurance companies have increasing financial reporting needs resulting equally from their structure and from general increasing demand for better and more transparent financial reporting. Financial reporting standard setters are under increasing pressure to improve the quality and transparency of financial reporting standards.

Better financial reporting means that accurate, useful, and relevant information is communicated to stakeholders. Transparency in financial reporting means that all relevant financial information is clearly communicated to stakeholders in such a manner that it is accurately interpreted and understood, and no relevant information to stakeholders is retained and not disclosed by the company.

However, even when Islamic insurance companies disclose financial information of the same quality as conventional insurers do, this may not be sufficient. Some of the Islamic insurers' stakeholders, such as policyholders, require more relevant and more transparent financial information. The two-tier structure of Islamic insurance companies demands more specific information to be disclosed to stakeholders.

Policyholders' Needs.  Financial reporting of conventional proprietary insurance companies focuses more on some of the stakeholders such as shareholders and markets than on other stakeholders such as the policyholders. This chapter will focus more on policyholders than on other stakeholders. The reporting needs of regulators, analysts, and other market players are not fundamentally different between conventional insurance and takaful companies. However, policyholders' requirements are different when it comes to Islamic insurance companies.

Policyholders use financial reporting to assess whether their rights are preserved by management and the company's owners. Financial reporting provides useful information on companies' obligations toward policyholders, as well as on the quality of their assets that will be ultimately used to settle their obligations to the policyholders.

Financial reporting of Islamic insurance companies should include relevant financial information about policyholders' rights. However, these rights not only encompass the companies' obligations toward policyholders but should also provide significant information on underwriting pools and underlying assets. The main difference between conventional insurers and Islamic insurers lies in the fact that, in Islamic finance, the assets underlying the underwriting pools are owned by the policyholders, whereas assets in conventional proprietary insurance companies are owned by the shareholders and must at all times be sufficient to cover their obligations to the policyholders.

Accordingly, disclosures about underwriting pools and underlying assets become fundamental in Islamic insurance companies. The operator has an obligation as part of its duties as the manager of the insurance operation and underwriting pools to provide transparent financial information on the balances and transactions relating to the policyholders' pools and underlying assets.

13.3 EXISTING ISLAMIC INSURANCE FINANCIAL REPORTING FRAMEWORK SHOULD BE IMPROVED TO ACHIEVE GREATER TRANSPARENCY

Greater transparency and standardized accounting principles are the basis of enhanced financial reporting practices needed by Islamic finance to achieve the recognition it deserves. Islamic insurance companies operate nationally and regionally and tend not to have comparable and transparent financial reporting. Standards are needed to transform the takaful industry from one that is regulated on an ad hoc basis to an industry that is based on a framework that caters for its specificities.

International Financial Reporting Standards (IFRS) represent the other available international financial reporting framework. However, this framework is not as appropriate as the AAOIFI for Islamic insurance companies, as it has been designed specifically for conventional insurance companies. Its main weakness resides in the non-separation of shareholders' and policyholders' operations, and in the absence of treatment of earnings prohibited by the Shari'ah.

The International Accounting Standards Board issued in 2004 IFRS 4 insurance contracts, its first standard on insurance contracts. This standard covers mainly the definition of insurance contracts and disclosures in the financial statements. A second standard is expected to be issued in 2011 that will address the measurement of insurance liabilities. These two standards are expected to result, in some cases, in a significant departure from the traditional accounting treatment of insurance contracts, which may result in differences in the financial statements of Islamic insurance companies and conventional insurance companies.

Takaful companies have not adopted a single financial reporting framework, and this has resulted in a lack of transparency and comparability of financial statements.

Presenting fairly the results of transactions in takaful companies' financial statements requires financial reporting methods that are not covered by international accounting standards or by national accounting standards designed for conventional insurance companies, a task which AAOIFI attempts to address.

On the other hand, the Islamic Financial Services Board was established to promote and enhance the soundness and stability of the Islamic financial services industry by issuing global prudential standards and guiding principles for the financial services industry, including insurance.

Which standards should be applied to achieve transparency in the financial reporting of takaful companies?

IFRS are better suited for conventional financial activities but are incapable of capturing all the specificities of Islamic insurance and translating them into a shared language. This is why, in all likelihood, AAOIFI standards should be the starting point for financial reporting of takaful companies, since:

• a typical takaful undertaking consists of a two-tier structure that is a hybrid of a mutual and a commercial form of company, and IFRS were not designed for such companies; and
• AAOIFI standards were designed on the basis of Shari'ah principles.

However, AAOIFI standards for takaful companies do not address all the issues that arise from their activities, especially how the interests of policyholders' and shareholders' funds are balanced. Moreover, AAOIFI's disclosure requirements should be enhanced in some cases.

13.3.1 Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) Standards

In a number of jurisdictions, Islamic insurance companies prepare their financial statements according to AAOIFI standards. The following AAOIFI standards that deal with Islamic insurance companies were issued in 1999 and 2000:

13.3.1.1 AAOIFI Standard No. 12

In the preface to FAS 12, it is stated that “the most appropriate means through which accounting standards [of Islamic insurance companies] could be developed and implemented [is] to present adequate, reliable and relevant information to users of the financial statements of” Islamic insurance companies. It is also stated that: “one of the prerequisites for the development of [ … ] trust is the availability of information that assures policyholders, investors and other parties that deal with the companies of the ability of the companies to achieve their objectives.”

FAS 12 defines the financial statements that should be published by Islamic insurance companies to satisfy the common information needs of users of financial reports.

FAS 12 illustrates the split between the shareholders' (“operator”) and the policyholders' statements. The complete set of financial statements defined in FAS 12 comprises the following:

Unlike IFRS, AAOIFI Standard No. 12 requires separate income statements for policyholders and shareholders. Shareholders' equity and policyholders' surplus (deficit) should also be separately disclosed. The statements of financial position and cash flows are common to both shareholders and policyholders. Such a split in the income statements and the equity and surplus of the shareholders and the policyholders, respectively, illustrates their different interests in the company.

Moreover, it is stated in paragraph 2/3 that “the form of and the classifications used in the financial statements should ensure a clear presentation of their contents. In addition, the terminology used to express the contents of the financial statements should enable their users to understand and comprehend the information contained therein.”

Paragraph 3/1 states that: “the financial statements should disclose all material information that is necessary to make those financial statements adequate, relevant, and reliable for their users.”

Income Statement and Statement of Policyholders' Revenues and Expenses.  AAOIFI's separate presentation of income and equity statements is extremely useful to policyholders and reflects the structure of the company. It details the components of the insurance operation and the resulting net surplus. It includes all revenue and expense accounts that would be presented in an IFRS income statement.

The main difference consists of presenting the remuneration of the operator for the services rendered to policyholders for the management of the insurance operation as well as policyholders' assets. Depending on the structure of the Islamic insurance company, the statement of policyholders' revenues and expenses details the wakalah and mudarabah fees paid to the operator instead of including operating and investment expenses. These expenses are borne by the operator who, in turn, charges the policyholders for the services rendered. Accordingly, the operator's income statement includes the wakalah and mudarabah fees received from policyholders and the operating and investment expenses incurred.

Statements of Changes in Shareholders' Equity and Policyholders' Surplus.  The statements of changes in shareholders' equity and policyholders' surplus detail the movements in shareholders' and policyholders' equity during the year. These statements provide the policyholders with details with regards to the accumulated surplus and indicate how much of it was distributed during the year or allocated to cover a potential current year deficit.

Statements of Financial Position and Cash Flows.  The statement of financial position provides a breakdown of total assets and liabilities representing shareholders' equity and policyholders' surplus at the end of the year. The main difference between this statement and the IFRS balance sheet is that it discloses separately policyholders' surplus (equity), whereas the only equity amount disclosed in the IFRS balance sheet belongs to the shareholders. The IFRS balance sheet discloses policyholders' rights within liabilities, being designed for conventional proprietary insurers.

IFRS considers policyholders as a third party to the company, whereas AAOIFI considers the shareholders as owning a service provider to the policyholders' insurance operation—namely, the takaful operator. The latter takes the place of the management employed by a conventional mutual insurer.

The statement of cash flows details the cash movements in the balances of the statement of financial position during the year.

Statement of Sources and uses of Funds in the Zakah and Charity Fund.  The AAOIFI Statement of Objectives and Statement of Concepts refer to “the role of the company in fulfilling its responsibility towards society.” This requires an Islamic insurance company to provide information in the financial statements “about its discharge of its social responsibility.”

The statement of sources and uses of funds in the zakah and charity fund provides details about the funds spent by the company on charitable causes. These funds are generated by transactions that are prohibited by Shari'ah and which should be set aside, including illegitimate earnings received by the company.

Notes to the Financial Statements.  The notes to the financial statements should include all the necessary material information to make the financial statements adequate, relevant, and reliable to their users.

Apart from the basic and general information that is required by most of the available accounting frameworks, the AAOIFI standards require the preparer of the financial statements to provide the following detailed information specific to Islamic insurance companies:

• the role of the Shari'ah supervisory board in supervising the company's activities and the nature of its authority in accordance with the company's by-laws and in actual practice;
• the basis for allocation among the policyholders of investment profits and the underwriting surplus where this is not retained to build up reserves;
• assets and liabilities relating to insurance operations, and assets and liabilities relating to shareholders' equity;
• remuneration of the party managing insurance operations and of the party managing policyholders' funds and shareholders' equity funds; and
• funds paid by the company from the zakah and charity fund during the period, and funds available in the fund at the end of the period.

13.3.1.2 AAOIFI Standard No. 13

The AAOIFI issued Standard No. 13 to “regulate the disclosure of the bases for determining and allocating surplus or deficit in Islamic insurance companies in order to present reliable and relevant information to assist users of financial statements in their decision making process.”

AAOIFI Standard No. 13 focuses on the relationship between the shareholders and the policyholders, and the transactions resulting from this relationship. It also provides specific disclosures on policyholders' underwriting surplus, its basis of determination, as well as the allocation of the surplus between the policyholders.

The main disclosures required by this standard are as follows:

13.3.2 How Could Greater Transparency in Financial Reporting of Islamic Insurance Companies be Achieved?

Greater transparency in financial reporting remains the responsibility of the companies themselves. Although the existing financial reporting framework applied by Islamic insurance companies could be improved, it could be considered as appropriate in addressing many of the financial reporting needs of Islamic insurance companies. But whether they are improved or not, financial reporting frameworks can only achieve greater transparency when properly applied.

Greater transparency in financial reporting could be achieved as discussed below.

13.3.2.1 Proper Application of the Financial Reporting Framework is Enforced by the Regulators and the Markets

The previous sections demonstrated that AAOIFI standards cover most of the characteristics and specificities of Islamic insurance companies. These standards focus on the main differences between Islamic and conventional insurance, including Shari'ah supervisory boards and the differences in interests between shareholders and policyholders.

A proper application of AAOIFI standards would provide the stakeholders of Islamic insurance companies with significant information on the relationship between the shareholders and the policyholders. This would cover the remuneration of the operator, the split of assets between shareholders and policyholders, the movement between the different asset pools, as well as the basis for the distribution of funds to policyholders. What is required by the AAOIFI standards is sufficient to provide the stakeholders with proper information about the company's operations.

In reality, the majority of Islamic insurance companies have not been rigorous in applying the existing financial reporting standards. Before considering modifying or revising the current financial reporting standards applicable to insurance companies, the state and the regulators should take the appropriate measures to enforce the application of these standards. In addition to such a legal and regulatory enforcement of current standards, the markets should sanction the companies that do not comply with the requirements of these standards. But most of the markets where Islamic insurance companies are currently established have not reached such a level of development and sophistication to sanction the companies that do not thoroughly apply the current financial reporting standards.

13.3.2.2 Harmonization and Proper Communication of Shari'ah Supervisory Boards' Decisions and Fatawa

To ensure that they operate according to Shari'ah principles, takaful companies employ Shari'ah supervisory boards to regulate their activities, including products sold and investment strategies. However, decisions and fatawa issued by the Shari'ah supervisory boards are not always communicated to customers. This lack of transparency does not enhance the stakeholders' trust in the company and limits the ability of policyholders to decide whether a given product meets their own understanding of what is Shari'ah compliant. Scholars' debates about Shari'ah compliance are an important part of the development of takaful, and these debates and the structure of new takaful products should be more widely available to encourage discussion among consumers of takaful products.

The financial reporting of a takaful company should represent to policyholders that its operations are in accordance with Shari'ah rules and principles. Such communication should occur on a timely basis and in a manner that could be understood by all stakeholders.

However, a proper communication on Shari'ah scholars' debates and decisions is not sufficient. The Shari'ah scholars should also strive to produce harmonized solutions to Shari'ah issues. A lack of harmonization results in a diversity of products and services apparently fulfilling the same commercial functions, in turn, resulting in a lack of transparency and problems of competitiveness between the companies.

13.3.2.3 Enhanced Disclosures on Policyholders' Funds, Allocation of Surplus to Policyholders, and Income from Prohibited Transactions

AAOIFI standards require disclosures on policyholders' funds and the determination and allocation of surplus and financing of deficits. The requirements in respect of movements between the funds should be enhanced. For example, movements from one fund or pool of assets to another should be properly disclosed and explained.

The individual rights of the policyholders should be clearly stated in the financial statements. There is a lack of transparency in the financial statements of some Islamic insurance companies regarding undistributed fund balances. Such funds would have accumulated over the years, and policyholders are unclear about their entitlements to such funds. It is unclear whether these funds belong to the current policyholders or whether previous policyholders are entitled to a share in these funds. (This “intergenerational” problem is also found in conventional mutual insurers.) It is frequent that the fund distribution remains at the discretion of the shareholders if not properly covered by the agreements between the shareholders and the policyholders and supervised by the Shari'ah board.

Movements in undistributed funds could sometimes occur without enough transparency. Deficits in funds could be financed by surpluses from other funds, although such financing may not be in compliance with the agreement between shareholders and policyholders. Because of the lack of transparency, the operators could be tempted to adopt such a practice in order not to provide a qard hasan to cover a fund's deficit.

Moreover, income from prohibited transactions is not always spent on charitable causes. The Shari'ah supervisory board should ensure that the company is fulfilling its social responsibilities and that it is fully transparent on the sources and uses of these funds.

13.3.2.4 Robust Corporate Governance Rules are Implemented

The current financial reporting practices of Islamic insurance companies do not provide adequate information to policyholders regarding the company's investment strategy, funds allocation, and revenues and expenses accruing to their particular investment funds.

Robust corporate governance rules are required to ensure adequate disclosure of relevant information about the company's investment objectives and policies, and operational guidelines that govern the relationship between the shareholders and the policyholders.

Robust corporate governance rules are also required to address potential conflicts of interest in Islamic insurance companies that could affect stakeholders' trust. The interests of stakeholders could diverge in certain situations and generate conflicts of interest.

Corporate governance rules should require that conflicts of interest be properly disclosed and communicated. Conflicts of interest could arise from the following:

• Shari'ah Scholars Holding Shares or Management Positions as a Result of the Limited Number of Shari'ah Scholars in the Takaful Markets This could impair their independence vis-à-vis the policyholders and policyholders' interests.
• Directors Elected from the Shareholders and Acting on Behalf of the Shareholders and the Policyholders The board of directors sets the remuneration of the operator in connection with wakalah and mudarabah agreements, as well as the distributions to policyholders. Although policyholders may have no representation in the organs of governance such as the board of directors or the Shari'ah supervisory board, they have every right to expect accountability and transparency on investments made on their behalf.1
• The Insurance Operator (Shareholders) in Charge of Allocating the Investments between Shareholders' and Policyholders' Funds An investment committee comprising representatives from the shareholders and the policyholders should be in charge of the investment's strategy, including risk mitigation and asset–liability management.
• Conventional Insurance Companies with “Takaful Windows” not Communicating Specifically on Takaful Operations Communication should cover whether these companies have a Shari'ah supervisory board and whether the proceeds from the takaful operations are invested in Islamic assets. Also, earnings from prohibited transactions relating to takaful operations should be spent on charitable causes.

13.4 CONCLUSION

Building public trust in Islamic insurance requires increasing transparency in the financial reporting from Islamic insurance companies. Takaful markets have been growing by more than 20 percent per annum. However, such a growth will not be sustainable unless there is transparency in financial reporting and stakeholders are satisfied about the financial information communicated to them.

This could be achieved by providing relevant, reliable, and useful financial information that addresses the needs of stakeholders through an adequate and enforceable financial reporting framework.

The International Financial Reporting Standards constitute the main available globally recognized financial reporting framework, having been adopted by most of the conventional insurance companies. Although it may be appropriate for conventional insurers, it may not be totally appropriate for Islamic insurance companies that have different structures and operations.

The AAOIFI financial reporting framework caters for the specificities of Islamic insurance companies, especially the disclosure of the relationship between shareholders (the operator) and policyholders, as well as policyholders' rights. It also requires compulsory disclosures on the role of the Shari'ah supervisory board in supervising the company's activities. AAOIFI Standard No. 13 focuses on this relationship and on protecting policyholders' rights by requiring specific disclosure of the operator's remuneration and policyholders' funds.

However, greater transparency in financial reporting will not be achieved just by adopting AAOIFI. A number of Islamic insurance companies report under AAOIFI, but they do not always disclose all the financial information required. A market discipline and robust corporate governance rules are required to ensure that transparency in financial reporting is achieved. Corporate governance rules are also needed to address potential conflicts of interest in Islamic insurance companies.

The IFSB, being a major contributor to the development of a transparent Islamic financial market, is currently developing a corporate governance standard that aims to enhance transparency and financial information by enforcing appropriate disclosure requirements and focusing on the protection of policyholders' interests. The IFSB should also continue encouraging and contributing to the development of Islamic insurance standards. This is required in order to continue building public trust in the Islamic insurance markets and in the companies operating in these markets.

 

 

Note

1 The IFSB has issued an Exposure Draft of a standard on the corporate governance of takaful companies. Among its proposals is that takaful companies should have a governance committee to represent the interests of policyholders.