Chapter 4

Corporate Governance and Stakeholder Rights in Islamic Insurance

Simon Archer, Rifaat Ahmed Abdel Karim, and Volker Nienhaus

4.1 INTRODUCTION

Corporate governance (CG) has been a major preoccupation of public policy and in academia since the 1990s. In the U.K., for example, the government commissioned a series of reports on the subject from various committees, starting with the Cadbury Report in 1992. However, awareness of some of the main factors that give rise to CG issues has deeper historical roots, notably in the work of Berle and Means (1932) and Coase (1937). This work highlighted the problems that arise from the separation between the ownership (that is, shareholders) and the control (that is, management) of industrial corporations. Managers have both the incentive and the means to run the corporations in their own interests rather than in the interests of the shareholders. This can be considered as the classical statement of the problematic nature of corporate governance. Economists have addressed this problematic through Agency Theory (AT—Jensen and Meckling, 1976) and through Transactions Cost Economics (TCE—Williamson, 1975, 1996).

For reasons that will be elaborated below, this classical statement, with its exclusive focus on conflicts of interest between shareholders and managers, may be thought to offer an excessively narrow view of the CG problematic. For the purpose of this chapter, a definition of corporate governance will be used that avoids this narrow shareholder focus: corporate governance is defined as “a set of organizational arrangements whereby the actions of the management of a corporation are aligned as far as possible with the interests of its stakeholders” (IFSB, 2006; Archer, 2004). Stakeholders are, in turn, defined as members of groups who have certain rights in respect of (that is, a stake in) the corporation. Such a pair of definitions takes account of the fact that debates about corporate governance tend to focus on the identities of stakeholders as well as their rights. Indeed, both Agency Theory and TCE have been developed to consider stakeholders (principals, in AT terminology) other than shareholders—for example, bondholders and other creditors.

Rights of stakeholders may include:

• Property rights—such as
  • the right to sell or otherwise transfer shares
  • the right to receive cash flows.
• Information rights—such as the right to receive an annual report, or to attend annual and extraordinary general meetings, of the company.
• Control rights—such as the right to vote at general meetings and to appoint and dismiss members of the board of directors or the supervisory board of a company.

Holders of non-voting ordinary shares, for example, have property rights and information rights, but not control rights.

The literature on corporate governance in financial institutions also points out that shareholders are not the only group that needs to be considered as stakeholders of such institutions (see, for example, OECD, 1999; BCBS, 1999). Depositors of banks and policyholders of insurance undertakings (and especially of insurance mutuals) are examples of other stakeholder groups. In the case of Islamic financial institutions (IFIs), there are particular reasons for considering investment account holders (depositors whose funds are placed with an institution on a profit-sharing and loss-bearing basis) and policyholders (who subscribe to and hold their policies on a mutual basis) as being stakeholders along with the shareholders of these institutions.

Moreover, for reasons of public policy, the industries to which financial institutions belong are prone to information asymmetries, adverse selection, and moral hazard problems, and therefore, have become subject to regulation, which gives rise to further CG issues. In the case of IFIs, their obligation to follow Shari'ah rules and principles in their operations raises additional CG issues of Shari'ah governance.

The remainder of this chapter is structured as follows. Section 4.2 examines two different models of corporate governance that are found in the literature and in practice, with reference to financial institutions and to insurance undertakings in particular: the Anglo-Saxon or neo-classical model, which retains a focus on shareholders as the key stakeholders; and the Continental European or neo-corporatist model, which considers a broader set of stakeholders. Section 4.3 considers CG issues in the insurance industry, with particular reference to mutual insurance (of which takaful is a form). Section 4.4 examines the various models of takaful institutions that were described in Chapter 2 of this volume in terms of the CG issues that they raise. Section 4.5 sets out some concluding remarks.

4.2 THE NEO-CLASSICAL AND NEO-CORPORATIST MODELS OF CORPORATE GOVERNANCE

A brief outline of the two main models of corporate governance and of related CG issues will be given here. These two models differ in terms of their conceptions of stakeholders and their rights, and, by implication, as regards the functions, and to some extent the structure, of their organs of governance.

4.2.1 The Neo-Classical Model

4.2.1.1 General Considerations

The neo-classical model of corporate governance focuses on financial stakeholders (primarily shareholders, but also bondholders and other creditors) and threats to their interests arising from conflicts of interest between them and the management (principal–agent problems, in AT terminology) and between different groups of stakeholders—for example, shareholders and bondholders (principal–principal problems, in AT terminology). The main issue is how to prevent management from taking advantage of information asymmetries (their superior knowledge of the corporation's condition and prospects) to manage the corporation in their interests to the detriment of those of the financial stakeholders. Since the rights of creditors are generally considered to be protected by the terms of their contractual relationship with the corporation and by their legal right to appoint an administrator if the corporation defaults on its financial obligations toward them, the main focus is on protecting the interests of shareholders as residual claimants (as their claims are subordinated to those of creditors). Within the AT framework, two kinds of mechanisms that serve to mitigate principal–agent problems are referred to as bonding and monitoring. Bonding provides a type of control right and consists of management entering into binding agreements with stakeholders to act or refrain from acting in certain ways. A common form of bonding is to link management remuneration to the achievement of specified financial objectives. Monitoring is a type of information right which consists of stakeholders having the right to receive information on the company's financial position and results. The utility of monitoring to stakeholders is very limited unless it is combined with control rights that allow the stakeholders to use the information to discipline management.

Williamson (1996, ch. 12) points out that shareholders, as equity investors or residual claimants, require a well-developed governance structure to protect their interests, while providers of debt finance do not require any such structure unless “things go badly”—that is, in case of default. The well-developed governance structure available to shareholders is an organ of governance in the form of the board of directors (BoD). The main protection to shareholders comes from their right to appoint and dismiss the members of the corporation's BoD.

Under the influence of the neo-classical model, the main focus of public policy on corporate governance in the U.K. and the U.S. is on attempting to ensure that the BoD acts to protect the interests of shareholders. An example of this may be seen in the succession of committees set up in the U.K. since the early 1990s (Cadbury, Greenbury, Hampel, Turnbull, Smith, and Higgs) and their proposals culminating in the U.K. Financial Reporting Council's “Combined Code of Corporate Governance” issued in 2003. One of the main issues was the role of non-executive directors and their independence from the executive directors, in general, and from the chief executive, in particular. In the U.K., members of senior management sit on the BoD as executive directors, and the chief executive may also be the chairman of the BoD, although the “Combined Code” discourages this. In the U.S., there are no executive directors except that the chairman of the BOD may be, and often is, the chief executive officer.

The BoD is a far from perfect means of protecting shareholders' interests, for several reasons, including the following:

• Although shareholders in principle may appoint and dismiss members of the BoD, in practice—especially if the shareholdings are dispersed—the chief executive may appoint “cronies,” rather than independent-minded directors.
• The BoD will not serve to mitigate the problem of asymmetric information between management and shareholders unless a sufficient number of its members have the competence and independence of mind to act on behalf of the shareholders generally.
• While shareholders with large shareholdings may mitigate the problem that results from dispersed shareholdings by carrying out monitoring of management on behalf of shareholders generally, they may also use their control over the composition of the BoD to cause it to act in their particular interests, rather than in the interests of shareholders generally.

To mitigate these problems, the BoD, as the main organ of governance, has been invested with various additional organs of governance in the form of committees of non-executive directors, such as:

• an Audit Committee to attend to matters of financial reporting;
• a Nominations Committee whose function is to seek competent and independent-minded nominees for membership of the BoD, to avoid the latter being dominated by executive directors and the cronies of the chief executive; and
• a Remuneration Committee, which is supposed to ensure that BoD members and senior management receive an appropriate but not excessive level of remuneration.

4.2.1.2 The Issue of Corporate Social Responsibility

The neo-classical model relies on the concept of the “responsible shareholder”—namely, that shareholders are able and willing to act (via the BoD) so as to induce corporate management to adopt socially responsible practices. Socially responsible practices include fair and ethical conduct toward groups such as customers and employees who are not considered as stakeholders within the model. There is little evidence, however, of shareholders being effective in inducing socially responsible management practices, unless a particular socially irresponsible practice threatens the value of their shareholdings. In other words, it is the market discipline of the stock market, rather than “responsible shareholders,” which may discourage socially irresponsible behavior by management. The discipline of market competition may also afford protection to customers against unethical or unfair practices by corporations, such as over-pricing or poor service. To function properly, the market requires adequate information which has to be disclosed by the corporation. We will return to this point when discussing the corporate governance of insurance undertakings below.

4.2.1.3 The Challenge of Globalization

As the BoD, as the essential organ of governance, is designed in the neo-classical model to protect shareholder interests, its membership can be chosen to do this irrespective of the country of domicile of the shareholders. Indeed, one effect of globalization may be to reduce societal or political pressures on boards of directors to follow socially responsible policies.

4.2.2 The Neo-Corporatist Model

The neo-corporatist model is associated particularly with continental European countries such as Germany and Sweden, in which there has been a tradition of cooperation (sometimes referred to as “tri-partism”) between the managements of corporations, the representatives of (organized) labor, and the public authorities. For large corporations (more than 2,000 employees), this model is exemplified in Germany by a two-tier board structure consisting of a supervisory board and an executive board. The former is composed of non-executive directors of whom half (including the chairman) are shareholder representatives, while the other half consists of representatives of employees (including external representatives of organized labor) and in some cases a representative of the regional state or Land. The executive directors sit on an executive board chaired by the chief executive. The latter attends meetings of the supervisory board but has no vote. The supervisory board has the power to dismiss the chief executive.

4.2.2.1 The Issue of Corporate Social Responsibility

In principle, one function of the supervisory board, and especially of the members who are not shareholder representatives, is to steer management toward employee-friendly and socially responsible policies and practices. However, it is not clear how effectively this function is performed in the context of globalization, as discussed below.

4.2.2.2 The Challenge of Globalization

The neo-corporatist model has the merit of making a clear separation between the monitoring function of the BoD and the executive function of senior management, and incorporates a concept of stakeholder that is wider than shareholders. However, it is unwieldy in a context of international operations, where multiple host societies and employees in numerous countries as well as different jurisdictions need in principle to be considered. There is a natural tendency for stakeholders in the corporation's country of origin to be more effectively represented in the supervisory board than those in other countries.

4.2.3 Conclusions

In the case of financial institutions generally and insurance undertakings in particular, the neo-classical model of corporate governance seems deficient in that it reserves the status of stakeholder to shareholders only. The neo-corporatist model avoids this problem, but requires some re-specification to take account of the implications of globalization. In addition, the two-tier board structure is top-heavy and is employed in practice only in the case of large corporations whose size makes their operations a matter of public concern.

4.3 CORPORATE GOVERNANCE ISSUES IN THE INSURANCE INDUSTRY

The key CG issue that is specific to the insurance industry is the status of policyholders. In discussing this issue, attention must be paid to the crucial difference between

• proprietary (or stock) insurance companies, the equity capital of which is held by ordinary shareholders;
• conventional mutual or cooperative forms of insurance companies which have no shareholders, and the equity capital of which is held by the policyholders; and
• Islamic insurance (takaful) undertakings, which have both shareholders' equity (that of the takaful operator) and funds that belong to policyholders.

This section will focus mainly on the first two types: proprietary companies and conventional mutuals. Takaful undertakings will be analyzed from a CG perspective in Section 4.4.

4.3.1 General Remarks

While it is clear that in mutual insurance, policyholders have a status as stakeholders which is more than that of “mere” customers, since they own the equity of the company, the position of policyholders in proprietary insurance is less clear, as discussed below.

Another distinction that may have CG implications is that between life insurance and non-life (general and accident) insurance. In general, policyholders in non-life insurance are able to end a policy after one year and to transfer their business to another insurer without any penalty (“exit option”). On the other hand, most of the various forms of policy offered by life insurance companies (including Islamic “family takaful” undertakings) incorporate a savings or investment element, the value of which builds up only over the years. High acquisition and administrative costs are usually charged to the policyholders in the early years of the contractual period of their policy. Ending such a policy involves “surrendering” it and receiving its “surrender value”; doing this may impose a penalty on the surrendering policyholder, in that the effective rate of return received on the surrendered policy may be very low or even negative in the earlier years of a policy because of the upfront charges. Holders of such policies may, therefore, be to a greater or lesser extent “locked in.” They lack a viable exit option, which restricts the effectiveness of market discipline. Therefore, institutional arrangements gain importance to allow stakeholders to raise their voice and bring their interests to the attention of the decision makers (a “voice option”).1

4.3.2 CG Issues in Proprietary Insurance

As indicated above, the key CG issue that is specific to insurance is the status of policyholders. From the neo-classical perspective, policyholders in a proprietary insurance company are considered as customers rather than as stakeholders, as they have no ownership of the equity of the company. As customers, policyholders may look to market forces, especially competition, to ensure that they receive value for money. An insurance policy, however, is the sort of product in relation to which value for money may be hard to evaluate, since the quality of the product depends critically on how claims are handled, and this may be discovered only after premiums have been paid for many periods.

Thus, on the one hand, this view of policyholders as being protected by competition may be somewhat rosy even for non-life insurance. For life insurance, on the other hand, it raises serious problems in the case of participating policyholders—that is, holders of “with profits” policies. Such policyholders have certain property rights, such as the right to receive cash flows when the policies mature, and certain information rights, such as information on the surrender value and the expected maturity value of their policies. However, they may have no control rights, and the information they receive (for example, on investment strategies) in addition to the annual report, which is in the public domain, tends to be minimal. This raises the question of how their interests (that is, the value of, and the implicit rate of return on, their investment in their policies) are to be protected, especially given that there may be a conflict of interest between them and the shareholders.

These are no trivial issues, as can be seen from the numerous scandals in various countries over the “mis-selling” of investment products by life insurance companies and the resultant losses suffered by policyholders in recent decades. Reliance purely on “market forces” such as competitive pressures to protect such policyholders' interests has been shown to be inadequate. Measures taken to remedy this situation have generally consisted of regulatory requirements regarding information rights, namely for much greater transparency at the point of sale regarding the risk characteristics of products, and for the seller to ascertain that a product meets a customer's requirements. To get relevant information is a necessary, but hardly a sufficient, condition for the protection of policyholders' interests: discontent on the part of policyholders with management decisions must be formulated and communicated to the decision makers. The neo-corporatist two-tier approach implants, in principle, a communication platform into the governance structure of corporations.

If a neo-corporatist perspective is adopted, the issue of control rights for participating policyholders has to be considered. As will be discussed below in connection with mutual insurance, this raises the further issue of how such rights would be exercised. The Department of Finance Canada carried out a major consultation exercise in 2003 into the corporate governance of insurance companies, including both proprietary companies and mutuals. Certain proprietary companies give some control rights to participating policyholders, and issues that were raised included:

• whether it would be preferable to give them greater protection through disclosure and greater accountability to ensure that policyholders' reasonable expectations are met, in return for a reduction of their “general political voting rights” at general meetings; and
• the number and role of “policyholders' directors” and the setting up of a “policyholders' affairs committee” to exercise control rights on policyholders' behalf through disclosure and greater accountability to ensure that policyholders' reasonable expectations are met.

4.3.3 CG Issues in Mutual Insurance

In mutual insurance, the undertaking belongs to the policyholders, who have the right to appoint and dismiss the members of the BoD. The managers are thus employed by the policyholders to perform underwriting, fund management, and administrative functions.2 While mutual insurance has the merit of avoiding the conflicts of interest between policyholders and shareholders that may arise in proprietary insurance, the agency problems associated with conflicts of interest between policyholders as owners (principals) and the management as agents are fully present. The major CG issue is how to create a governance structure that is effective in protecting policyholders' interests, with particular reference to these agency problems.

As noted above, while policyholders (though not necessarily all classes of them in non-life companies) normally have the right to attend and vote at general meetings, this raises problems similar to those of dispersed shareholders in stock companies (limited capacities to process information, information biases, divergence of interests and preferences, lack of sufficient incentives to bear the costs of policyholders' interests, problems of articulation). The result may be lack of monitoring of management, and hence, ineffective exercise of policyholders' control rights.

Historically, a number of mutuals have shown a tendency to build up excess underwriting reserves, substantially beyond what are required for an adequate solvency margin. While the existence of such reserves makes the company “super-solvent,” it raises a number of related problems:

• intergenerational equity—a not insignificant part of the benefits of the premiums paid by past policyholders does not go to them, but to future policyholders who may thereby enjoy lower premiums or more generous treatment in the event of a claim;
• the failure by policyholders to exercise their control rights—a similar problem to that of dispersed shareholders—which means that excess reserves leave considerable scope for managerial slack; and
• “orphan assets”—it is not clear to whom the assets financed by the excess reserves belong. It might be thought that they belong to the current policyholders, even if this raises the issue of intergenerational equity. But in some recent cases of the acquisition of mutuals by proprietary insurance companies, the courts have allowed a substantial portion of such assets to pass to the acquiring shareholders, including assets of underwriting funds financed by past underwriting surpluses, as well as assets financed by past profits retained.

On the other hand, there are cases on record of mutual companies having the opposite problem—namely, inadequate reserves to absorb the effects of major errors in risk or asset–liability management. One such case was the Equitable Life crisis in the U.K., where annuity policies had been issued with guarantees that the company found itself unable to honor. The chief executive of Equitable Life was himself an actuary, and this seems to have given him an unchallengeable position which was an important factor in the CG failure that was reflected in seriously inadequate management of risks and of asset–liability matching.

There is no definitive solution to the ineffective exercise of control rights by policyholders and the consequent failure to mitigate agency problems in the form of self-serving behavior by management. However, non-executive directors who think and act independently from the management may play an important role in mitigating such problems.

In conventional mutuals, there is no problem of a conflict of interests between policyholders and shareholders, and of management tending to favor the latter, which we find in the case of takaful undertakings as we analyze below.

4.4 CORPORATE GOVERNANCE ISSUES IN TAKAFUL

The basic underlying concept of Islamic insurance is solidarity, and its most appropriate institutional manifestation would be a mutual insurance undertaking. However, as mentioned in Chapter 1, takaful undertakings operate on the basis of a business model that is a hybrid of proprietary and mutual insurance companies. This may not be by choice, but rather because the legal infrastructure in most jurisdictions in which takaful companies operate, which are predominantly emerging and developing markets, does not provide for the establishment of mutual insurance companies. In addition, even where the requisite legal forms are available, modern regulatory practices on such matters as solvency margins make it very difficult, if not impossible, to start a new mutual insurance undertaking. In this context, a key role of the proprietary component of the hybrid structure is to provide capital backing3 for underwriting so that solvency requirements are met. This hybrid model has produced two main stakeholders in a takaful company—namely, shareholders and policyholders.

4.4.1 Shareholders as Stakeholders

As in any proprietorship, the shareholders as promoters and owners of the takaful operator provide the business capital in the form of equity and have full control of the operations. They have the right to appoint all organs of governance in the company—namely, the BoD, external auditors, and the Shari'ah board. Furthermore, the BoD and the executive management are in charge of managing the operations of the company, and hence, have the right to make all crucial decisions with respect to the establishment and design of the takaful underwriting, business strategy, the level of contributions paid by the policyholders, the consideration charged for managing the underwriting and investment of the policyholders, and so on. This also includes the right to decide on the appropriation of the surplus among policyholders, which is generated from the results of the underwriting and investment activities, at the end of a financial period.4

Although the shareholders own the TO company, the underwriting and investment funds belong to the policyholders by virtue of the contributions they pay. Funds arising from both these activities are treated from the administrative and financial, but not legal, viewpoints as a separate set of funds or entity within the takaful undertaking. This means that the shareholders of the TO do not own these funds; instead, the TO is entrusted with managing them as an agent on behalf of the policyholders.

Hence, in addition to the returns generated from investing their equity, the TO on behalf of the shareholders is also entitled to a consideration from managing the underwriting activities and investing the funds of the policyholders. The former is usually governed by the wakalah contract for which the takaful operator receives a fee on behalf of its shareholders. For managing the investment activities, the shareholders receive a mudarib share of the profits if the investment is based on mudarabah or a fee if it is a wakalah contract. This means that the shareholders are exposed to the business risk relating to the consideration received from managing the takaful undertaking and the investments of the policyholders. In addition, they are exposed to the fiduciary risk if there are losses resulting in a deficit due to misconduct and negligence.

Since capital backing may be provided by the TO in the form of an interest-free (qard) loan facility to an underwriting fund that is in deficiency, the TO's shareholders would also be exposed to a credit risk in respect of the loan. Although juristically, the policyholders are obliged to meet any underwriting deficiency by paying a “call” issued by the TO, provided the deficiency is not due to any misconduct and negligence on the part of the latter, in practice, none of the TOs has exercised this option. Market forces may dissuade takaful companies from making a call on policyholders to finance repayment of a debt because potential policyholders would be discouraged from joining a takaful company if they had to compensate past deficiencies and would opt to participate in another company. In addition, it is uncertain whether the courts in the various jurisdictions would support the management in its claim to have recourse to the policyholders by making a call to finance a deficit or repay a loan previously provided by the shareholders. Repayment of such a loan would, therefore, normally be made out of future underwriting surpluses.

4.4.2 Policyholders as Stakeholders

Although, like the shareholders, the policyholders in a takaful company are the main stakeholders, their equity consists of ownership of the underwriting activities and the associated funds and (in life takaful) the investment funds; they have no equity stake in the company's share capital. Furthermore, under current arrangements they have no representation either in the BoD and the executive, management or in any of the other organs of governance. Rather, their relationship with the TO company is governed by the contributions they pay which entitle them to ownership of the underwriting and investment funds of the undertaking. They also have a claim on the assets of these funds in case of liquidation.

As in conventional mutual companies, the policyholders in takaful undertakings are entitled to have their claims paid, provided there are sufficient underwriting funds to finance payouts. They may also be entitled to a share in the distribution of any underwriting surplus.5, 6 However, the distribution of the underwriting surplus depends, among other things, on the regulations of the jurisdiction in which the takaful underwriting operates,7 the ruling of the Shari'ah board of the company, and the discretion of the BoD. The latter may decide not to distribute the surplus if it is not adequate, or if it is thought to be in the best interests of the undertaking to reinvest part or all of the surplus to build up reserves. Alternatively, the BoD may decide to reduce future contributions rather than distribute the surplus.

Since the policyholders own the takaful underwriting activities and funds, they are exposed to insurance risk, which they share collectively among themselves but without any corresponding control rights to protect their interests. This is different from the case of policyholders in mutual insurance companies, who, in addition to their right to be compensated for their claims and to receive a share of any distribution of underwriting surplus, have most of the stakeholder rights possessed by shareholders of proprietary companies.8

4.4.3 Governance Issues

The situation of policyholders and shareholders in a takaful undertaking is comparable to that in Islamic banks where there are likewise two principals—namely, shareholders and investment account holders (IAH). In both types of institution, the management is the agent; but given the absence of control and other governance rights for both policyholders and IAH, it is likely that the management would prioritize the interests of shareholders. This is simply because the shareholders in both takaful undertakings and Islamic banks have control of the governance organs in both institutions and there are no incentive structures to make the management act in the interests of the policyholders or the IAH.

In a takaful undertaking, one way in which the BoD may serve the interests of the shareholders is by setting the wakalah fee and mudarib share of profit at a level that would give the shareholders a return on their equity which is comparable to (or even better than) that on a similar class of instruments in the market. However, at the same time the management would need to be mindful that it has enough funds to meet the claims of the policyholders and to achieve a surplus (or at least to avoid a deficit) at the end of the financial year.9

Having enough funds to meet policyholders' claims would help the company to maintain its current policyholders and attract new policyholders in order to continue operating in the future and grow. On the other hand, achieving an underwriting surplus would be attractive to the policyholders because they could benefit from it either in the form of cash distribution (dividend) or a reduction in future contribution. The management would also have an interest in achieving a sizeable underwriting surplus, to build up solvency margin reserves so as to minimize the risk of having to make a loan from the shareholders' funds to finance any deficit that occurs (and, if the TO acts as a mudarib, to provide its management fee).

If the policyholders are dissatisfied with the services of the TO or the returns they receive from it in the form of their share in distributions of the surplus, they can only “vote with their feet” by discontinuing their contractual relationship with the company. This seems to be the only means available to them to voice their discontent and discipline the management because of their lack of stakeholder rights in their capacity as policyholders and their lack of ownership of a tradable instrument (such as shares) to signal their dissatisfaction to the capital markets, which is an option available to shareholders.

However, keeping its policyholders satisfied is important for the management of the TO because it is the consideration generated from managing both the underwriting and investment business of the policyholders that determines, among other things, the returns of the shareholders. This suggests that shareholders have a long-term interest in monitoring the performance of the BoD so that it exercises proper control on the management in order to look after the interests of the policyholders. This is what Archer, Karim, and Al-Deehani (1998) call “vicarious monitoring” in the case of IAH in Islamic banks. Short-term opportunism or lack of effective competition may, however, allow behavior that benefits shareholders at the expense of policyholders.

In Islamic banks, a similar situation exists where the shareholders benefit from the mudarib share of profits generated from investing IAH funds. According to Al-Deehani, Karim, and Murinde (1999), it would be in the interest of the shareholders to keep their equity at a minimum and to mobilize as much IAH funds as possible because this does not expose the shareholders to additional financial risk. In addition, this would allow the shareholders to benefit from the leverage effect resulting from allocating the profits between the shareholders and IAH.

Given that in takaful companies the excess funds of the policyholders are typically invested on the basis of the mudarabah contract, the shareholders are expected to benefit in the same way as the shareholders of Islamic banks do by managing IAH funds. This is particularly so in life or family takaful insurance, where the investment profits are usually more than the surplus generated from the underwriting business; in fact, the underwriting outturn is a deficit which is compensated by the investment profits. It should be remembered that while the shareholders' return from managing the policyholders' investment is based on performance, this is not the case for the underwriting business performed under a wakalah contract where the shareholders may receive their wakalah fee regardless of the outturn. Moreover, if a mudarabah contract is used, the size of the underwriting fee depends on the size of the surplus, which provides an incentive for the management to produce larger surpluses than are required either for strictly underwriting purposes or in the policyholders' best interests.

A prudent management of a takaful undertaking would build up reserves from the underwriting surpluses. Such a practice, which would also be encouraged by insurance regulatory authorities, provides a solvency margin to absorb deficits in future, thus mitigating the exposure of the shareholders to the risk of having to provide a loan to finance any deficiency.

This use of underwriting surpluses to build up solvency reserves has some similarity to the “profit equalization reserve” (PER) in Islamic banks, which is formed from the profits of the mudarabah before allocating the bank's share of mudarib. This reserve is mainly used to “smooth” the returns of IAH if they do not match the returns in the market in order to mitigate the risk of the account holders withdrawing their funds from the bank.10

As an alternative to establishing the PER, the management of Islamic banks get the consent of the shareholders to give up part or all of their mudarib share to the IAH to motivate them to continue placing their funds with the bank. This is known as “displaced commercial risk,” which is comparable to the situation where the shareholders in a TO have to provide capital backing in the form of a standby loan facility to finance an underwriting deficit. The difference, however, is that in the case of Islamic banks the amount paid to the IAH from the shareholders' share of the mudarib profit is not refunded to the shareholders, while in the takaful undertaking, the financing of the deficiency is in the form of a loan which should be paid back to the shareholders, unless the latter agree to write it off. However, having to provide this capital back-up to meet solvency requirements imposes capital costs on the TO.

4.4.4 The Islamic Insurance Model in Sudan

The world's first takaful company was established in 1979 in Sudan, where only Islamic insurance companies are currently licensed to operate. All takaful companies are subject to the 2003 Insurance and Takaful Act.11 The Sudan model differs from the one discussed above, which prevails in almost all other countries that have introduced takaful insurance. Although the business model is also a hybrid one of proprietorship and mutual insurance companies, the Act gives the policyholders more rights and stronger governance than the shareholders compared to what is practiced elsewhere. It also requires insurance companies to keep policyholders' books separate from those of the shareholders.

The policyholders have the right to monitor the performance of the management through the policyholders' general assembly. In this body, the policyholders:

The shareholders also have representatives on the BoD.

As in other takaful companies, in Sudan the BoD has the right to determine how the underwriting surplus should be allocated. It may decide not to distribute part or all of the surplus and retain it in reserves. Although the shareholders are prohibited from partaking in the underwriting surplus, until recently, they were expected to finance any deficit that may occur. However, this obligation ceased to exist after the establishment of the Policyholders Protection Fund (PPF), which helps insurance companies to meet their obligations toward the policyholders in case the company does not have adequate funds. The insurance companies are represented on the board of trustees of the PPF, which is managed by the insurance supervisory authority. It is financed by the insurance companies on the basis of their gross premiums.

The shareholders have also recently been allowed to manage the investment of the policyholders' funds, including the retained underwriting surpluses, together with their own funds on a mudarabah basis, provided they form an independent and separate unit from the company for this activity. This was in response to complaints from shareholders who argued that the system has deprived them of returns they used to earn from the companies that they had established long before the practice of Islamic insurance companies. Under this arrangement, the shareholders are exposed to the fiduciary risk of losses due to misconduct and negligence.

The Sudan model seems more in line with conventional mutual insurance in terms of the stakeholder rights, and especially the control rights of the policyholders. The establishment of the policyholders' general assembly is an innovative development that attempts to mitigate the imbalance of ownership and control in the takaful model that is practiced elsewhere. While the policyholders in the latter model are the owners of the underwriting and investment activities, they lack the necessary governance mechanisms to monitor the performance of their assets and otherwise protect their interests. However, in the Sudan model, having an assembly and representatives on the BoD, the policyholders would rank pari passu with the shareholders of takaful companies, in terms of stakeholder rights with respect to monitoring the performance of their underwriting activities and having a say in the allocation of the underwriting surplus.

Although shareholders have been relieved of the burden to finance any deficiency, the establishment of the PPF may induce moral hazard for the management—for example, by not being accurate in their pricing of risk. However, the shareholders still have an incentive to monitor the performance of the management so that the company achieves a surplus. This is because, under the new arrangement, the shareholders benefit from managing the policyholders' funds and surplus. In addition, they would not wish to be exposed to the risk of financing a deficit. On the other hand, the policyholders also have a vested interest in monitoring the management through their representatives in the BoD because they would benefit from the distribution of surplus. Moreover, if they prefer lower premiums to distributions of surplus, they have the means to influence the management so as to avoid unnecessarily large surpluses.

4.5 CONCLUDING REMARKS

The debate on adequate arrangements for the protection of policyholders' interests in takaful undertakings has begun only recently. Various institutional options can be considered which are not mutually exclusive but may be combined in different ways. For example:

• Regulators may enact appropriate disclosure requirements for takaful operators to facilitate market discipline as well as informed choices and “voices” of takaful policyholders.
• Regulators and takaful operators should consider institutional arrangements that support the interests and recognize the rights of takaful policyholders (especially of life products with a long-term perspective and a significant savings/investment component) resulting from the peculiar ownership structure of Islamic insurance. Different ideas have been put forward—for example:
  • to introduce or to enhance the role of an external actuary who provides not only the management and BoD but also the policyholders with relevant information on financial risks and executes a “whistle-blowing” function in critical situations;
  • to extend the mandate of the Shari'ah board and entrust it with the role of an advocate of the interests of policyholders; and
  • to establish a specific Governance or Policyholders' Committee (comprising, for example, an actuary, a Shari'ah scholar, and a non-executive director) which should evaluate the overall governance structure of the takaful undertaking and give due consideration to the policyholders' rights and interests.

Each of the aforementioned models has specific advantages and limitations, which leaves enough room for further concepts. One could explore, for example, whether the neo-corporatist model with a two-tier board could be adapted to the specifics of takaful. One could also discuss whether CG problems of takaful could be eased if national laws were changed to allow for the establishment of “true” mutual insurance undertakings (although the issue of capital adequacy and solvency margins for new mutual undertakings would remain). Such a discussion must take into account the process of demutualization in the Western world, as well as the specific Shari'ah requirements for insurance and the interaction of takaful undertakings with the other segments of the emerging global Islamic finance sector.

Although controversies about the appropriateness of different governance architectures have just begun, there is an emerging consensus among regulators in most jurisdictions that takaful regulations must be more than marginal modifications of governance standards for conventional insurance companies.

 

 

Notes

1 On “exit and voice” as options for the protection of stakeholders' interests, see Hirschmann (1970).

2 As in proprietary insurance, some or all fund management functions may be outsourced to fund management companies.

3 This capital backing typically takes the form of an interest-free (qard) loan facility from the TO to an underwriting fund that is in deficit. Such an arrangement raises issues that are discussed in the text below.

4 The underwriting result (surplus or deficit) needs to be distinguished from the profit or loss on investment activities. Strictly speaking, the underwriting result is shared by the policyholders, as in a conventional mutual, while investment profits may be shared between policyholders and shareholders so as to provide a source of remuneration to the takaful operator. However, it has been accepted that a TO may manage the underwriting as a mudarib, in which case the TO may receive a percentage share of the underwriting surplus. Nonetheless, there may be practical objections to this on the grounds that the TO as mudarib (a) does not share in any underwriting deficit and (b) may be motivated to aim at unnecessarily high underwriting surpluses in order to maximize the TO's remuneration. Please see the discussion of this issue in the text below.

5 The issue of the policyholders' entitlement to a distribution of any underwriting surplus is a controversial one still being debated among the Shari'ah scholars, as highlighted in Chapter 3. A recent view, voiced by some Shari'ah scholars to address the concerns raised by their colleagues on this issue, is to abolish such an entitlement. While this would address such concerns and would not deprive the policyholders of their ownership of the takaful operations, it would make the surplus available for building up reserves and/or reducing future contributions, among others.

6 It is worth noting that the recently promulgated insurance regulations by the Saudi Arabian Monetary Authority, which apply to takaful companies, enable the shareholders to partake in the surplus.

7 Recently, the Shari'ah Advisory Council of IAH Bank Negara Malaysia has ruled that the distribution of surplus from a tabarru' (donation) fund to the policyholders is permissible from a Shari'ah perspective. This fund belongs to the policyholders because it is formed from their contribution, which is paid on the basis of donation.

8 Their property rights do not include the right to sell or transfer shares; otherwise, they have the same property, control, and information rights as shareholders.

9 If the relevant underwriting fund has reserves built up from previous surpluses, then a deficit in an individual financial year may be absorbed provided an adequate solvency margin is maintained. Given an adequate solvency margin, there is no underwriting requirement to achieve a surplus. This is an argument against the practice of using a mudarabah contract to remunerate the TO for underwriting management, as it makes the remuneration of the TO depend on the size of the underwriting surplus. Please see the discussion of this issue in the text.

10 The shareholders may also benefit from the PER whereby the management can use the funds in the reserve to beef up the dividends of the shareholders. However, the authors are not aware of any disclosure made by an Islamic bank of such a practice.

11 In Sudan, the term takaful is used for life, health, and other personal types of insurance, while “Islamic cooperative insurance” is used for non-personal types of insurance.