Chapter 6

Business Conduct in Islamic Insurance with Special Reference to Emerging Markets

Arup Chatterjee

6.1 BACKGROUND

The takaful (Shari'ah-compliant) industry, although relatively young, has grown significantly as the Islamic alternative to conventional insurance and evolved from being a regional business to a global one. In the coming years, it will evolve rapidly, gaining critical mass and holding the promise of building brand recognition globally. The industry is still in a development process whose eventual outcome is the convergence of the practice of Islamic financial intermediation with its conceptual foundations. The major challenges faced by the national and cross-border takaful operators in this growth process include raising customer awareness and education, and developing performance benchmarks and market-based standards at par with the conventional insurance industry. Typically, this will involve areas such as: (a) ongoing monitoring of compliance with high ethical standards; (b) transparency, including disclosure of different terms and conditions and of charges; (c) frequency of reporting; and (d) principles and procedures concerning ex ante Shari'ah compliance of products and services complemented with the ex post attestation of such compliance. Better compliance will enable the insurers and the intermediaries to identify potential risks before problems occur, in order to protect their reputation and revenues, and most importantly, their customers.

But how much reliance can one place on market forces where liquidity, transparency, and other underlying characteristics of markets are deficient? Specifically, which elements of market discipline work better in immature environments? Most practitioners think that, as markets plainly do not function well in low-income countries, then it must be the case that market discipline also does not work, and that, therefore, these countries need to rely more heavily on prudential regulation.

To summarize, local institutional deficiencies and weaker market and formal information infrastructures, couple, with current levels of market monitoring, may not be adequate. The noticeable offsetting factors to them being: (a) the less complex character of takaful insurance business in low-income countries; (b) the growing internationalization of these markets through the presence of international insurers who have established business lines known as “Islamic windows”; and (c) the smaller size of the undertakings individually and in comparison to the overall insurance business. This increases the expectation for the likely development of market monitoring mechanisms as the market expands. The use of information intermediaries (accounting firms and rating agencies) is also growing rapidly, but their independent ability to contribute to market discipline seems rather limited.

This chapter contrasts the risks and regulation that would be needed in the case of Islamic financial intermediation operating according to the International Association of Insurance Supervisors' Insurance Core Principles (ICPs); and reviews the different channels of market discipline based on the current practice of which Islamic insurance undertakings need to take cognizance, discussing how they work, and what the policy and institutional prerequisites are, and outlining existing empirical evidence wherever available. An organization of the Islamic insurance industry that would allow it to develop in compliance with its principles and prudent risk management, and facilitate its regulation, is proposed.

6.2 BUSINESS ENVIRONMENT IN EMERGING MARKETS

A sound regulation and supervision framework is essential for improving the efficiency of any insurance market. High-quality insurance regulations and standards assure market participants that sound practices are being applied, thereby increasing market transparency and confidence. Reforms without attendant prudential regulations and supervisory measures foster chaotic market situations. Emerging market economies need special consideration in this regard due to their particular economic and financial situations. In general, problems begin with lax management within insurance companies. Poor internal controls and moral hazard, where owners lack the proper incentives to act prudently and to supervise managers, often leads to institutional failures.

The market can play a crucial role in disciplining bad performers, but this function may not be performed satisfactorily in the presence of inadequate information or distorted incentives. Some governments in emerging market economies also tend to be very cautious about exposing the insurance sector to market discipline. Basic infrastructure shortcomings for the establishment and maintenance of a sound insurance system—for example, accounting systems, financial markets, and a legislative framework—can aggravate matters by failing to identify problems, and thus, preventing them from being addressed in a comprehensive and timely manner.

In 2007, Wolters Kluwer Financial Services' Insurance Compliance Solutions Group in the United States identified the top 10 reasons why insurers are found to be out of compliance during market conduct exams. In order to help insurers avoid the non-compliance violations that are most prevalent in their business area, it provided top 10 lists for property and casualty insurance, as well as life and health insurance (see Table 6.1). These violations are equally true for most emerging markets.

Table 6.1 Top 10 Most Common Market Conduct Compliance Criticisms

Property and casualty insurance	Life and health insurance
1. Failure to properly terminate a policy	1. Failure to acknowledge, pay, or deny claims within specified time frames
2. Failure to acknowledge, pay, or deny claims within specified time frames	2. Using unapproved or unfiled forms
3. Using unapproved or unfiled rates	3. Failure to adhere to advertising requirements
4. Failure to communicate a delay in the settlement of claims in writing	4. Failure to adhere to replacement requirements
5. Failure to notify of producer appointments or terminations	5. Failure to notify of producer appointments or terminations
6. Improper documentation of underwriting policies	6. Using unapproved or unfiled rates
7. Improper documentation of claims policies	7. Failure to adhere to grievance and appeals requirements
8. Using unapproved or unfiled forms	8. Failure to provide required disclosures (such as explanation of benefits or guaranty fund notices)
9. Failure to produce requested records for an examination	9. Improper documentation of claims policies
10. Failure to provide required disclosures (such as selection/rejection issues or notices in the claims process)	10. Failure to properly terminate a policy

Source: Adapted from press release, “Wolters Kluwer Financial Services Identifies Top 10 Criticisms on Insurance Market Conduct Exams,” Wolters Kluwer Financial Services, Minneapolis, Minn., United States, June 27, 2007

Strong regulatory and supervisory arrangements (insurance supervisory authorities, prudential regulations) that complement and support the operation of market discipline are indispensable to the stability of insurance markets. However, in the absence of effective market discipline, the entire burden of external control falls on insurance supervisors who may not have the requisite capacity.

Accounting systems are central to the provision of the information needed by investors, consumers, managers, supervisors, and other interested parties with an actual or potential stake in an enterprise so that they can make reasonable assessments of the effectiveness of the enterprise's operations and its future prospects. High-quality accounting systems, taking into account the particular nature of the insurance sector, provide authorities with the practical means to perform proper audits, while at the same time being a vital resource for the management of companies and other interested parties. Ensuring that the supervisory authorities have regular access to reliable information about insurance companies is a crucial issue for emerging markets. Absence of this mechanism has often delayed, in the past, the discovery of financial problems in insurance companies and has thus failed to prevent many of them becoming insolvent.

Availability of reliable basic data is also essential for effective market discipline. In particular, insurance premiums are calculated on the basis of the law of large numbers. For this reason, the establishment of reliable policy data such as loss frequency and loss severity is indispensable in calculating correct insurance premiums and the technical provisions that are crucial for maintaining the solvency of insurance companies and for establishing the stability of insurance markets. Reliable mortality tables are also essential for life insurance products. In many cases of emerging market economies, an insurance company does not have enough past insurance policies to create a reliable database, or a data collecting system itself has not yet been properly established. Thus, the collection of claims data through the cooperation of insurers should be encouraged. The insurance supervisory authorities should also establish a reliable claims database that will help insurers and supervisors confirm the right benchmark for each of the elements which go into pricing for various categories of products.

Although reforms in many cases may be urgently required, it must be realized that insurance markets differ widely from one another. It is indispensable that any insurance system reform take into account the particular character of that jurisdiction and be appropriately adapted to it. In addition, regulatory and supervisory frameworks have to be adapted on a regular basis in order to match changing conditions, perceptions, and economic needs.

The take-up of insurance, especially life insurance, has historically been limited in those emerging markets that have a large number of followers of Islam. This behavior appears to be due to the strong influence of their perceptions about whether or not the products are compliant with Shari'ah. Similar to other conventional financial products, life insurance is perceived to have prohibited elements of uncertainty (gharar), gambling (maisir), and interest income (riba). Uncertainty stems from the notion that the outcome of the insurance contract is not known at the time it is created and varies according to the time of death of the insured. Gambling stems from the notion that the insured may gain large amounts (that is, profit) from the insurance coverage if certain events take place. Interest income stems from the notion that the premiums are invested in non-Shari'ah-compliant, interest-bearing instruments. A limited awareness of life insurance and its benefits among the citizens has also been responsible for limiting the take-up of such products. This is partly driven by cultural factors, such as the reliance on the extended family network, and partly by structural factors, such as the provision of generous benefits by the state in the Arab world, in the event of death or disability. In response to this Shari'ah sensitivity, takaful has begun to emerge as an alternative to conventional insurance. Although there is little data available, experts point out that the increase in the number of Islamic insurance companies is an indicator of its rising demand.

A recent study by Booz Allen Hamilton1 that looked at five key enablers of growth in the Arab insurance industry—legal frameworks, regulatory bodies and processes, the nature of competition, skills and training, and market-led initiatives—has identified substantive gaps, on the lines mentioned in the preceding paragraphs, that need to be addressed. While pointing out that life insurance is significantly underdeveloped, the study mentions that there is a rapidly growing demand for takaful insurance, and suggests that the legal framework should also promulgate adequate legislation to address this form of insurance. It further recommends that regulators should identify, develop, and disseminate risk-management best practices that take into account the contractual relationships of Islamic insurance products. Regulators need to ensure the availability of training programs to educate the market on these relatively new products, besides taking a more active role in developing the expertise of their employees.

6.3 FRAMEWORK OF BUSINESS CONDUCT AND BEST PRACTICES

The terms “business conduct” and “market conduct” are both employed in the relevant literature with somewhat different meanings. Some authorities use “market conduct” in the wide sense of encompassing any product or service relationship between the insurance industry, insurers, agents, and individuals alike, and the public, while others (including the Islamic Financial Services Board) prefer to use “business conduct” in this sense. This chapter follows the IFSB usage. As such, business conduct is influenced by many factors, including laws, established best practices, codes of conduct, and consumer expectations.

Market conduct requirements form one of the key blocks in the IAIS's common structure for assessment of insurer solvency.2 Risk-sensitive financial requirements can only fulfill their intended role if the insurer meets sound governance, market conduct, and public disclosure requirements. As with governance, some risks may be addressed only through market conduct requirements, rather than by setting regulatory financial requirements. Therefore, in order for the regime to be fully risk sensitive, it is important for the supervisor to have the ability to require the insurer to hold additional capital or to take additional safety measures as needed to protect policyholders through ongoing operations and to provide enough funds to support partial or full withdrawal from marketplace activities and winding-down operations. In other words, it seeks to ensure that customers are able to select the insurance product that best meets their needs. A prerequisite thereto is adequate, timely, and accurate provision of information by insurers and intermediaries.

Improper business conduct may have a direct prudential impact on an insurer, or may be damaging to its reputation. This can lead to severe indirect consequences to its financial position and its ability to operate effectively. Liabilities that were not anticipated may arise if an insurance contract is unclear or if the policyholder has not been adequately informed or advised about its nature during the sales process. Business conduct requirements should, therefore, include treating customers fairly and paying attention to their information needs. Contract parties should be provided with timely and complete information about policy benefits, including the associated risks and expenses and the consequences of any embedded options, over the period until all obligations under the contract have been satisfied.

In practice, additional obligations arising from mis-selling, in particular, have proved to be substantial in some jurisdictions. Even if selling is not carried out by the insurer, but by intermediaries, more often than not, obligations may fall on the insurer itself as a result of inappropriate use by the intermediary of the insurer's literature or sale of the insurer's products. The insurer should thus ensure it has adequate selection and management processes for its sales channels. Business conduct requirements should also extend to the integrity of an insurer in the area of reinsurance and as an institutional investor, and to other operations of an insurer on the financial markets—for example, to attract capital or establish credit lines.

Any failure to meet the qualitative requirements of a regulatory regime, such as in the areas of governance, business conduct, and public disclosure, may have severe direct consequences for the financial soundness of an insurer. It may also have indirect consequences, which flow from a tarnished reputation that may, in turn, have a considerable negative impact on the effective operation of the insurer.

Any inadequacies in the operation of an insurer need to be resolved by the insurer, by addressing any deficiencies in its policies, procedures, and practices. The supervisor should thus use its powers to require that the insurer satisfactorily resolves such deficiencies, and to intervene in the management of the business, if necessary. The supervisory regime should specify which solvency information should be made public to enhance market discipline and provide strong incentives for insurers which allows them to treat policyholders fairly while conducting their business in a safe, sound, and efficient manner.

The IAIS Insurance Core Principles, 2003 provide a globally accepted framework for the regulation and supervision of the insurance sector. They provide the basis for evaluating insurance legislation and supervisory systems, and apply to both insurers and reinsurers. A broad understanding has now evolved that takaful operators, to the extent possible, must conform to standard insurance regulation and supervision requirements applicable to conventional insurers.3

ICPs 24 to 28 (Table 6.2) more specifically deal with markets and consumers, and are applicable for addressing issues of business conduct that are an essential area of the supervision in the insurance sector and may have a reputation risk or prudential impact on insurers.

Table 6.2 IAIS ICPs for Markets and Consumers

ICP 24 Intermediaries The supervisory authority sets requirements, directly or through the supervision of insurers, for the conduct of intermediaries.

ICP 25 Consumer protection The supervisory authority sets minimum requirements for insurers and intermediaries in dealing with consumers in its jurisdiction, including foreign insurers selling products on a cross-border basis. The requirements include provision of timely, complete, and relevant information to consumers both before a contract is entered into through to the point at which all obligations under a contract have been satisfied.

ICP 26 Information, disclosure and transparency toward the market The supervisory authority requires insurers to disclose relevant information on a timely basis in order to give stakeholders a clear view of their business activities and financial position and to facilitate the understanding of the risks to which they are exposed.

ICP 27 Fraud The supervisory authority requires that insurers and intermediaries take the necessary measures to prevent, detect, and remedy insurance fraud.

ICP 28 Anti-money laundering, combating the financing of terrorism (AML/CFT) The supervisory authority requires insurers and intermediaries—at a minimum, those insurers and intermediaries offering life insurance products or other investment-related insurance—to take effective measures to deter, detect, and report money laundering and the financing of terrorism consistent with the Recommendations of the Financial Action Task Force on Money Laundering (FATF).

Source: Insurance Core Principles and Methodology, International Association of Insurance Supervisors, 2003

6.3.1 ICP 24 Intermediaries

In many insurance markets, intermediaries serve as important distribution channels of insurance. They provide the interface between consumers and the insurer. Their good conduct is essential to protect consumers and promote confidence in insurance markets. For this reason, intermediaries should be directly or indirectly supervised. Where intermediaries are supervised directly, then the supervisory authority should be able to conduct on-site inspection, when needed.

The essential criteria require intermediaries to:

The supervisory authority should have requisite powers to take corrective action, including applying sanctions, directly or through insurers, and canceling the intermediary's license or registration, when appropriate. It should also be able to take action against those individuals or entities that are carrying on insurance intermediation activity without license or registration.

6.3.2 ICP 25 Consumer Protection

Requirements for the conduct of insurance business help to strengthen consumer confidence in the insurance market. The supervisory authority requires insurers and intermediaries to treat their customers fairly, paying attention to their information needs. A good claim resolution process is essential for the fair treatment of consumers. For this purpose, some jurisdictions have established extrajudicial claim resolution mechanisms, such as independent panels or an ombudsman.

The essential criteria require insurers and intermediaries to:

The supervisory authority should set requirements for insurers and intermediaries with regard to the content and timing of provision of information on the product,7 including the associated risks, benefits,8 obligations and charges, and other matters related to the sale, including possible conflict of interest to existing or potential policyholders.

In the case of takaful operators, there will also be a need to ensure that they do not falsely hold themselves out as takaful firms or their products as Shari'ah compliant, either explicitly or implicitly—for example, by using names with Islamic overtones.9

The advanced criteria require insurers and intermediaries to:

The supervisory authority shall also provide information to the public about whether and how local legislation applies to the cross-border offering of insurance, such as e-commerce. It may also issue warning notices to consumers, when necessary, in order to avoid transactions with unsupervised entities and promote the consumers' understanding of the insurance contracts.

6.3.3 ICP 26 Information, Disclosure, and Transparency toward the Market

Public disclosure of reliable and timely information facilitates the understanding by prospective and existing stakeholders of the financial position of insurers and the risks to which they are subject, regardless of whether they are publicly traded or not. Supervisory authorities are concerned with maintaining efficient, fair, safe, and stable insurance markets for the benefit and protection of policyholders. When provided with appropriate information, markets can act efficiently, rewarding those insurers that operate effectively and penalizing those that do not. This aspect of market discipline serves as an adjunct to supervision.

The essential criteria require insurers to:

The supervisory authority should monitor the information disclosed by insurers and take necessary action to ensure their compliance with disclosure requirements.

The advanced criteria require insurers to provide information, which also includes quantitative information, on relevant risk exposures.

6.3.4 ICP 27 Fraud

Fraud can be perpetrated by any party involved in insurance—for example, insurers, insurers' managers and staff, intermediaries, accountants, auditors, consultants, claims adjusters, and policyholders. It results in reputation as well as financial damage, and social and economic costs. The supervisory authority has an important role to play in combating fraud in insurance in its jurisdiction and requires that insurers and intermediaries address it effectively. It communicates with other supervisors in addressing cross-border fraud. Most jurisdictions have legal provisions against fraud in insurance. In many jurisdictions, instances of fraud are criminal acts.

The essential criteria require the supervisory authority to:

The supervisory authority should mandate insurers and intermediaries to ensure high standards of integrity of their business and allocate appropriate resources and implement effective procedures and controls to deter, detect, record, and, as required, promptly report fraud to appropriate authorities. This function is normally under the responsibility of senior staff of the insurer and intermediary.

ICP 27 is a general principle that is universally applicable and appears to require no adaptation to apply to takaful.

6.3.5 ICP 28 Anti-Money Laundering, Combating the Financing of Terrorism (AML/CFT)

Money laundering and financing of terrorism are criminal acts under the law. Money laundering is the processing of criminal proceeds to disguise their illegal origin. The financing of terrorism involves the direct or indirect provision of funds, whether lawfully or unlawfully obtained, for terrorist acts or to terrorist organizations. Insurers and intermediaries—in particular, those insurers and intermediaries offering life insurance or other investment-related insurance—could be involved, knowingly or unknowingly, in money laundering and financing of terrorism. This exposes them to legal, operational, and reputation risks. Supervisory authorities, in conjunction with law enforcement authorities and in cooperation with other supervisors, must adequately supervise insurers and intermediaries for AML/CFT purposes to prevent and counter such activities. Insurers and intermediaries—at a minimum, those insurers and intermediaries offering life insurance products or other investment-related insurance, must comply with AML/CFT requirements, which are consistent with the FATF Recommendations applicable to the insurance sector:

• perform customer due diligence (CDD) on customers, beneficial owners, and beneficiaries;
• take enhanced measures with respect to higher-risk customers;
• maintain full business and transaction records, including CDD data, for at least five years;
• monitor for complex, unusual large transactions, or unusual patterns of transactions, that have no apparent or visible economic or lawful purpose;
• report suspicious transactions to the Financial Intelligence Unit (FIU);
• develop internal programs (including training), procedures, controls, and audit functions to combat money laundering and terrorist financing; and
• ensure that their foreign branches and subsidiaries observe appropriate AML/CFT measures consistent with the home jurisdiction requirements.

ICP 28 is a general principle that is universally applicable and appears to require no adaptation to apply to takaful.

In addition, the IAIS Principles for the Conduct of Insurance Business (1999) sets out how one can expect to improve insurer, intermediary, and consumer relationships and thereby strengthens consumer confidence and protection. Table 6.3 provides a snapshot of this document. It consists of a set of common principles that provides basic standards of business conduct, fostering competition while protecting the integrity of the market. It also signals the types of behavior that may warrant enforcement of action (where applicable), and provides guidance for setting local rules so that those adversely affected by market abuse have a facility for seeking appropriate redress.

The IAIS foresees a need for a standard on market conduct in relation to the assessment of insurer solvency, to include, for example, issues such as treating customers fairly, reasonable expectations, constructive liabilities, and mis-selling. This will give due emphasis to these important aspects of managing the obligations to policyholders which the liability values reflect. Operational risk in this area means that cross-reference to the papers on financial requirements will be made. Work on this standard will indicate the need for supervisory review to complement qualitative and financial requirements to ensure that all risks are covered and the regime is risk-responsive.

The IAIS also considers public disclosure critical to achieving transparency and comparability. Two standards on public disclosure have already been adopted by the IAIS, and further work is in hand. As work on solvency issues progresses, it will become clear whether there is any need for a separate standard on public disclosure within a solvency context.

The IFSB-IAIS Issues paper has identified “transparency, reporting and market conduct” as one area that is critical to the regulatory and supervisory framework of the takaful industry. The outcomes may need to recognize the unique characteristics of takaful insurance and the proportionality factors, such as nature, scale, and complexity of risks; while interpreting and applying them. This may then lead to adaptation of the criteria contained in the ICPs and standards for the takaful industry by the IFSB, and to the development of specific guidance in the form of standards in the near future.

Table 6.3 Principles for the Conduct of Insurance Business

Principle 1: Integrity	Insurers and intermediaries should at all times act honestly and in a straightforward manner.	avoid misleading and deceptive acts or representations not rely unreasonably on any provision seeking to exclude or restrict any duty or liability which it has under a legislative framework and/or accepted practices
Principle 2: Skill, Care, and Diligence	In conducting their business activities, insurers and intermediaries should act with due skill, care, and diligence.	act competently and diligently discharge duties prudently arrange adequate protection for customers' assets
Principle 3: Prudence	Insurers and intermediaries should conduct their business and organize their affairs with prudence.	maintain adequate financial resources, including adequate liquidity maintain effective risk management systems not assume risks without taking due account of the possible consequences
Principle 4: Disclosure of Information to Customers	Insurers and intermediaries should pay due regard to the information needs of their customers and treat them fairly.	provide relevant and meaningful information in a timely and comprehensive manner to customers explain benefits and any risks to the customer in a fair and balanced way explain obligations of both the service provider and the customer in a clear manner provide information about the intermediary, insurer, product (for example, price, cover, conditions, risk factors, guarantees, special exclusions, charges, estimated returns, and so on)
Principle 5: Information about Customers	Insurers and intermediaries should seek from their customers information which might reasonably be expected before giving advice or concluding a contract.	obtain sufficient information about customer/s to assess their insurance needs inform customers about their duty to disclose relevant information treat as confidential information which a customer expects to be kept confidential
Principle 6: Conflicts of Interest	Insurers and intermediaries should avoid conflicts of interest.	ensure fair treatment for all customers by enforcing disclosure and confidentiality a service provider should not unfairly place its interests above those of its customers
Principle 7: Relationship with Regulators	Insurers and intermediaries should deal with their regulators in an open and cooperative way.	keep the regulator/supervisor promptly informed of significant events ensure an effective compliance program is in place for meeting the regulator's requirements
Principle 8: Complaints	Insurers and intermediaries should support a system of complaints handling where applicable.	ensure a simple, accessible, and equitable process of dispute resolution by setting up alternative dispute resolution mechanisms
Principle 9: Management and Control	Insurers and intermediaries should organize and control their affairs effectively.	management and control systems shall vary depending on size and complexity relatively simple procedures in the case of a one-person business sophisticated systems of control are necessary in the case of a complex organization directors and senior managers must be fit and proper systems of internal control and record keeping for adequate monitoring robust arrangements for meeting regulatory standards and requirements and preventing market abuse or financial crime (including detection and prevention of money laundering and terrorism financing)

Source: Adapted from Principles for the Conduct of Insurance Business, IAIS, Switzerland, 1999

6.4 CRITICAL DRIVERS FOR DEVELOPING MARKET INFRASTRUCTURE

While insurance market infrastructure investment typically benefits the entire market in the long run, and often requires the active participation of all insurers, it is hard to obtain industry consensus to collaborate collectively on such market improvement initiatives. Improvements in insurance market infrastructure can have substantial economic benefits to the public that outweigh the benefits to any particular insurance company.

Invoking market discipline on institutions involved in Islamic insurance business can help alert regulators to risky or self-serving behavior by insiders; it can also act directly on insider incentives. But market discipline is unlikely to emerge in the absence of relevant market and information infrastructures. A key challenge for the Islamic insurance industry is to develop business conduct standards and practices which are Shari'ah compliant and in conformity with a conventional regulatory framework. This will ensure that business transactions are structured according to both secular law and Shari'ah.

As part of the market-led initiatives, the Booz Allen Hamilton study has also recommended a greater involvement of industry-wide bodies, whether at the local or regional level. Experience suggests that this is a valuable enabler for the development of the market by providing forums for the harmonization of standards and activities, and for the sharing of best practices. In particular, policy makers and regulators can play a valuable role in promoting more active involvement by industry associations, encouraging the adoption of market standards, fostering the availability of granular market statistics, generating consumer awareness of insurance, and raising the profile of the industry to attract new talent.

The critical drivers10 identified for investment in insurance market infrastructure and enhancing the efficiency and competitiveness of Islamic insurance in emerging markets are as follows.

6.4.1 Improving Insurance Regulation and Supervision

The primary foundation of an insurance market is an adequate insurance law. The law must provide a specific definition of takaful (Islamic insurance) and set forth the fundamental insurance market parameters, such as indicating the regulatory authority responsible for supervision, licensing criteria, and prohibited practices. Following the development of an appropriate legal framework,11 an Islamic insurance industry sector should be supervised on the basis of a robust regulatory framework. Lacking these preconditions, the takaful insurance industry can be curtailed by arbitrary, opaque, ineffective, and unnecessarily costly regulatory interventions, which can diminish consumer confidence and dissuade potential consumers from taking up insurance. In addition, lack of effective supervision can discourage foreign and domestic investors from supplying capital, retard insurance market efficiency, and dampen industry development.

Essential aspects of supervision are protecting policyholders from the possible insolvency of their insurers and ensuring that insurers treat policyholders fairly. Conflicts of interest and lack of transparency in the way that insurance intermediaries are typically remunerated may inflate premiums and reduce choice by limiting competition.12 There is a growing awareness in the market that such conflicts of interest may need to be better supervised or regulated even if that means it needs to question some established market practices which may be harmful to consumers and competition. Moreover, because of the potential for money laundering, effective supervision is also a concern to the integrity of the global financial system.

There has been steady progress to improvise and modify regulatory frameworks by the IFSB, with the aim of ensuring harmonization and consistent adoption, application, and implementation of these evolving standards in line with the IAIS's Insurance Core Principles. This remains a formidable challenge but is absolutely required to avoid regulatory arbitrage by industry and certain Islamic jurisdictions.

To meet the above demands, a supervisory agency requires adequate resources and guidance. The primary source for guidance is the IFSB and the IAIS. The IAIS issues global insurance principles, standards, and guidance papers, and provides training and support on issues related to insurance supervision; the IFSB develops standards specific to takaful. Both of them organize meetings and seminars for their members. The Financial Stability Forum has recognized the IAIS as the relevant standard-setting body for insurance supervision and included the IAIS's core principles of insurance supervision among the 12 key standards for financial stability. Compliance with the ICPs speeds developing countries' integration into the global economy. Establishing an effective supervisory body also drastically reduces the potential for fraud and financial crimes, and signals foreign investors that the country intends to meet its responsibilities in the global financial system. Principles relating to supervisory independence, corporate governance, internal controls, and investment regulation present the greatest challenges.

6.4.2 Shari'ah Arbitrage

There are a number of different schools of thought regarding the Shari'ah across Muslim jurisdictions, of which the principal schools are the Hanafi, the Maliki, the Shafi, and the Hanbali. Even within the same school, there may be different interpretations of the Shari'ah. These differences, along with different interpretations by scholars as members of Shari'ah Supervisory Boards or as advisors within the insurers, if significant, further carry the risk of Shari'ah arbitrage, which entails complications for regulators. Reaching consensus and shared or harmonized guidance among scholars of different schools, evolving more unified institutional mechanisms for the adoption of common Shari'ah standards, and ensuring proper enforcement through effective internal controls for their compliance would allow the industry to grow and compete on a level playing field. Flexible and simpler interpretation of the basic tenets at the level of scholars would enhance public acceptability.

There is a need for more substantive work in the area of standardization of contracts and documentation that would reduce transaction costs and risks of litigation.

6.4.3 Collecting and Sharing Insurance Data

The insurance industry relies on information to function. While much of an insurer's added value comes from its superior ability to analyze and price risk, that ability requires having sufficient data to calculate losses and expenses per unit of exposure. Lacking adequate data, insurance companies tend to manage their balance sheets (amounts of reserves and investment selection) inefficiently, causing inefficiency in the use of capital and raising the cost of insurance. In this context, one must always remember that gathering and managing detailed statistical data differ from recording and compiling the aggregate data needed for financial reporting. Although both are essential to sound insurance markets, statistical reporting and financial reporting are different functions requiring different tools. In emerging markets, they are often confused.

Without sufficient data to estimate losses more precisely, any insurer, including a takaful insurer, will either set prices too low and eventually become insolvent or set prices too high and attract few customers. Neither scenario is good for market development. A robust market needs a sound system to collect, organize, and make available detailed data on losses and exposures. The more comprehensive, the better, as an industry-wide system of data collection can help to mitigate fraud, reducing the cost of insurance for all. Creating a data-sharing mechanism that protects confidentiality and preserves market neutrality is a complex challenge. Large insurers may perceive a competitive advantage from their larger database and may, therefore, resist pooling loss statistics on an industry-wide basis. Smaller insurers may balk at sharing costs. Consumers may fear anti-competitive motives in concerted industry action. The possibilities for improved risk classification systems and better understanding of the causes of loss often go unrecognized.

6.4.4 Shari'ah Compliance throughout the Product Life Cycle

For takaful operators, gaining approval from the Shari'ah board13 on the Shari'ah compliance of a product before its launch is vital. Equally important for firms is recognizing that Shari'ah compliance14 is a continuous process that means their products and services are adequately monitored. Unlike conventional insurance, this has implications for a takaful operator's prudential requirements as well as conduct of business. If some products breach Shari'ah compliance rules, this can adversely affect a firm's solvency. Effective monitoring of Shari'ah compliance by an Islamic firm may involve reinforcing more remote oversight of the Shari'ah board through the internal Shari'ah audit process, and by developing more knowledge and expertise within the firm.

6.4.5 Supporting Insurance Education

The crucial building block for a robust insurance market is a reliable cadre of insurance professionals, including actuaries, accountants, underwriters, lawyers, agents, claims personnel, policy administration and customer service personnel, managers, and supervisors. Formal training programs are, by far, the most efficient means to develop knowledge and skills in staff. However, since relatively few countries have formal professional training programs, on-the-job training dominates. Not only is on-the-job training generally deficient in ensuring accuracy, thoroughness, currency of practice, and uniformity of subject matter, but in a new company, there may be no one qualified to provide it either. Centralized institutes located in the capital city or at a university often reach only a limited number of employees and suffer from lack of curriculum materials in the local language and suited to the local market.

Many emerging insurance markets have minimal input from actuaries, and they have reduced efficiency, effectiveness, and product flexibility to show for it. Without the technical skill to evaluate risks and adapt products to local conditions and markets, market participants cannot innovate. Many emerging insurance markets, moreover, do not have actuaries within the supervisory agency, which weakens the supervisor's ability to monitor reserves, pricing adequacy, and solvency. Some emerging markets have no actuaries at all, which causes inappropriate reserving and non-enforced solvency requirements, further reducing market efficiency. The most cost-effective approach to improving the actuarial capacity is by combining local university resources with foreign or local-trained actuaries, and tailoring one of the many existing actuarial training curricula to a local market, to establish a local training curriculum and a certification program.

Debates over the interpretation of Shari'ah in a financial context, however, reflect disparate views on various issues, such as regulatory challenges and arbitrage, the perception that Islamic insurance is purely faith-based, and product innovation. Part of the dilemma can be attributed to the limited number of bona fide Shari'ah scholars with expertise in international finance. Divergent views between regions—such as between the Middle East and Asia—coupled with different regulatory standards in country jurisdictions and institutional infrastructure necessary for maintaining prudential standards, also impede attempts toward harmonization. With the increasing popularity of Islamic insurance, Muslim and non-Muslim countries will require a new generation of practitioners who understand how the modern legal system, Western common law, and international finance integrally function in a global economic system.

6.4.6 Educating Markets and Consumers on Standards

Since the spread of any form of insurance depends on consumer confidence, enlightened insurers safeguard their reputation. They police the marketplace through self-regulatory organizations. Through policy statements and codes, they shape the expectations of consumers regarding the benefits of insurance, responsible sales practices, the products offered, fair treatment in claims, ways to control losses, and other aspects of insurance transactions. In some markets, insurers also offer a grievance procedure to resolve consumer complaints. Creating a positive image can enhance consumer confidence and expand the takaful insurance market. To increase consumer awareness of how insurance works and can benefit them, consumer education campaigns should be undertaken.

6.4.7 Encouraging Ethical Market Discipline

The market can play a crucial role in disciplining bad performers, but only if there are proper incentives and adequate information. Countries without developed Shari'ah-compliant capital markets and insurance company rating agencies may exhibit less market discipline, particularly if most insurers are closely held. Rating agencies enhance transparency and strengthen market discipline. Potential investors, as well as agents and brokers of insurance products, use ratings of insurance companies. These ratings can influence the amount of business—that is, premium—placed with an insurer.

6.4.8 Promoting Institutional Development and Marketing

Like conventional insurers, takaful operators can use a variety of forms of technical assistance and training to strengthen their management and governance, from the development of actuarial databases and information management systems to new product development. Because insurance, in many cases, will not be taken up unless substantial efforts are made to educate consumers about its benefits, its success depends entirely on how well it is advertised and marketed.

6.4.9 Promoting Self-Regulatory Organizations

In emerging markets, it is common for insurers to perceive supervision as an unwelcome burden, and the supervisor as an opaque entity, creating an adversarial relationship between the private and public sectors that can diminish supervisory effectiveness. For effective supervision, an insurance supervisor may transfer a substantial part of the monitoring responsibility to the private sector through codes of corporate governance, standards for actuarial and accounting professions, and the expectations of investors, reinsurers, and consumers. To achieve this, the supervisor needs to foster an environment in which all stakeholders play an active role in improving the efficiency of the market.

6.4.10 Promoting Financial Inclusion

Islamic insurance also has the potential to blend both economic and social15 objectives and to address the ethical aspects of effective financing. As such, Islamic insurance is generally more acceptable16 in populations with moderate to strong inclinations toward managing their financial relationships in line with their beliefs. This can thus help in poverty alleviation through including a larger proportion of the population into the insurance system, providing access to credit, and effectively mobilizing savings.17

To protect the public from unfair market practices and to instill confidence in the financial services sector, insurance supervisors assume responsibility to oversee a wide range of company and intermediary practices (for example, sales, underwriting, and claims processing) through a variety of regulatory activities such as licensing, consumer complaint reviews, and on-site examinations. Taken together, these regulatory practices are referred to as business (or market) conduct regulation.

Since regulatory capacity in most emerging markets may not be sufficient, regulatory efforts need to be directed to the most significant issues that either have the greatest potential for consumer harm or that could weaken public confidence if left unchecked. In this context, the merit of adopting a risk-based approach is gaining more acceptability (see Table 6.4). This approach allows regulators working with each other and the industry to identify and prioritize issues based on their potential impact (risk) in order to achieve the desired legislative and regulatory outcomes based on a common understanding.

Table 6.4 Risk-Based Approach to Business Conduct18

(i) Specific outcomes at the micro-level that are within the control of individual firms or intermediaries: Compliance with laws: Market participants must comply with statutory, legal, and corporate obligations. Good corporate governance: Companies should identify and manage risks through internal controls, risk management, and business oversight mechanisms. Fair treatment of consumers and claimants: Market participants should accept ethical and honest behavior as the norm. Disclosure of information to enable consumers to make informed decisions: Consumers should have access to information that is simple and easy to understand. (ii) Broader outcomes at the systemic level that can only be achieved though the collective actions of the entire industry: Stable marketplace: Needs of consumers for understandable, available, accessible, and affordable insurance should be met. Proactive identification of issues: Collaboration between industry and other regulators to prevent issues from arising, rather than merely fixing problems after they occur. Fair dispute resolution: A process by which disputes are dealt with by participants in a fair, timely, and responsive manner should be in place. Note: The outcomes at the micro-level must be achieved before the outcomes at the systemic level can be fully realized.

6.5 CONCLUSION

Encouraging developments and trends in Islamic insurance lends confidence that this industry has taken off. There are various motivations and driving factors for the development of this industry, ranging from religious fervor to the opportunities that exist in finance for broadening and deepening the process of financial intermediation. These factors augur well for financial innovation and engineering, enhanced financial services penetration in national jurisdictions, and better diversification of risks.

Regulators must place increased reliance on transparency, public disclosure, and market discipline for the efficient development of takaful insurance. Counterparties and investors need to be clear about the risks that firms and the industry are taking in order to manage their own exposures. Market discipline is clearly necessary in order to have an appropriate mix of incentives and disincentives, thereby guiding the industry's evolution and development. Undoubtedly, the most important step that can be taken toward enhancing market discipline is to encourage more accurate and detailed disclosures of financial information. Intermediaries need to have sufficient knowledge of Shari'ah issues and their implications for takaful, besides possessing the competence to make these disclosures to the consumers and to explain why takaful insurance is relevant and how it is consistent with Shari'ah.

Competitiveness of Islamic insurance in future would depend on how governments and regulators in different emerging market jurisdictions perceive and nurture the future development of Islamic insurance, address the issues discussed, and develop institutional, regulatory, and supervisory frameworks. Integrity is part of any market's brand. Good compliance and enforcement will foster consumer confidence.

Takaful regulators, in particular, need to confer and compare national systems and dialogue with market participants so as to identify regulatory best practices and avoid duplicative regulatory work. It is also important for each regulator to understand and evaluate the major changes in the laws and regulations in other jurisdictions and the international implications of those changes. Promoting strong working relationships through regular, ongoing dialogue also creates better channels for communication when difficulties arise, as well as further accelerating efforts for the development of takaful globally through development in this tryst with trust.

Notes

1 Peter Vayanos and Hammoud Maher (2007), Promoting Growth and Competitiveness of the Insurance Sector in the Arab World (Booz Allen Hamilton).

2 The IAIS Common Structure for the Assessment of Insurer Solvency, International Association of Insurance Supervisors, February 2007.

3 Although this part may be subject to further study, some of the ICPs do appear to require some adaptation, or at least interpretation, to cater fully for takaful. In most instances, this is at the criterion level, rather than in the Principle itself. Paragraph 16 (p. 11), Issues in Regulation and Supervision of Takaful, Islamic Financial Services Board and International Association of Insurance Supervisors, August 2006.

4 According to the principles of al wakalah (agencies), the appointment of the agent by the insurer is of the broker by the insured is of utmost important. In fact, such appointments are widely practiced for the purpose of making the transaction and dealings between the insurer and the insured more effective. The governing principles for the agents and brokers are laid down in the Mejelle as follows: “Wakalat is for someone to put business of his on another and to make him stand in his own place in respect of that business.”

5 In an insurance contract, for the enforcement of the policy, the parties involved in it should have good faith. Therefore, non-disclosure of material facts, involvement of a fraudulent act, misrepresentations or false statements are all elements that could invalidate a policy of insurance. Allah says: “Do not misappropriate your property among yourselves in vanities but let there be amongst you traffic and trade by mutual good will.” (al-Qu'ran, Surah an-Nisa, 4:29).

6 See the discussion of the principles of mirath and wasiyah and their implications in Chapter 5 of this book.

7 An insurance policy binds the parties unilaterally by an offer and an acceptance in reliance on the principles of contract. The fundamentals required in an insurance policy are the parties to the contract, legal capacities of the parties, offer and acceptance, consideration, subject matter, insurable interest, and good faith, most of which are found in the general type of contract. For example, a contract is a promise by an offer and an acceptance, which must be fulfilled as Allah has commanded to the effect: “O ye who believe! Fulfil your obligations.” (al-Qu'ran, Surah al-Maidah, 5:1).

As for the legal capacity as to the age of the parties to the contract of insurance, a minor below the age of 15 (the age of rushd or majority or puberty) is not able to buy a policy unless the guardian holds the full supervision over the policy and the policy is for the benefit of the minor. Thus, the takaful siswa operated under the Syarikat Takaful Malaysia Bhd. allows an infant between the age of the majority and the 15th day of birth to hold a takaful policy for education which is under the supervision of the respective guardian (Sistem Operasi dan Tatacara Pelan Takaful Siswa, Syarikat Takaful Malaysia Berhad, nd. pp. 1–3). This operational method may be justified by the following Qu'ranic sanction: “Make trial of orphans until they reach the age of marriage; if then you find sound judgment in them, release their property to them; but consume it not wastefully” (al-Qu'ran, Surah an-Nisa, 4:6). The requirement of minimum age of the parties in an insurance policy is the same as required in a general contract. Hence, the above principles and other relevant principles relating to contract are basically applied to the formation of an insurance contract.

8 An insurance policy covers losses arising from the death, accident, disaster, and other losses to human life, property, or business. The insurer undertakes in the policy to compensate against the losses to the agreed subject matter. Such undertaking is considered as vicarious liability. For instance, in the case of ‘Aqilah practiced in the ancient Arab tribes approved by the Holy Prophet, if a person was killed by another from a different tribe either mistakenly or negligently, this would bring a liability to the members of his tribe to pay blood-wit to the heirs of the slain (see Uddin M. Musleh (1982), Concept of Civil Liability in Islam and the Law of Torts (Lahore: Islamic Publication Ltd.), p. 62; see also Niazi Liaqat Ali Khan (1988), Islamic Law of Tort (Lahore: Research Cell Dayal Singh Trust Library), p. 339).

Moreover, the rights and obligations in an insurance policy arise mainly from the laws of contract and tort. For example, in the case of a motor accident, the operator (insurance company) is liable on behalf of the person who causes that accident (for example, the insured) to compensate the victim. Here, the operator is bound by the terms stipulated in the proposal to pay that compensation under the principles of vicarious liability under the law of tort.

9 There is, however, no consensus between jurisdictions as to how far it is the supervisor's role to monitor misrepresentations, even in the conventional market.

10 Akhtar Shamshad, “Islamic Finance—Growth, Competitiveness and Sustainability,” 14th World Islamic Banking Conference, Bahrain, December 9–10, 2007.

11 There are several Shari'ah-based insurance companies established and operating today in the contemporary world—for example, in Malaysia, Sudan, Brunei, Qatar, and Saudi Arabia, to name a few. These Islamic insurance companies have been established and operate on the basis of Shari'ah-based enactment and regulations, approved by the Parliaments of the respective countries. A clear example, among such enactment and regulations, is the Takaful Act (Malaysia) 1984 (Act 312), which is one of the Acts of Parliament aimed at controlling insurance practices in Malaysia based on Shari'ah principles.

12 Systemic conflicts of interest arise where brokers act for both insureds and insurers. This matter has given rise to some tricky legal questions in the past, and no doubt poses problems for brokers in practice. One particular area of focus is broker remuneration. The European Commission considers that disclosure of remuneration does not, in itself, resolve the conflict. It notes that insureds have “seemingly low concern” about brokers' remuneration, but suggests that this may be because they do not actually realize how much brokers are paid. For a detailed discussion, see Commission Staff Working Document accompanying the Communication from the Commission Sector Inquiry under Article 17 of Regulation (EC) No 1/2003 on business insurance (Final Report) SEC (2007), Commission of the European Communities, Brussels, 1231, September 25, 2007.

13 Behind every Shari'ah-based insurance company, there is a council or board called the Shari'ah Supervisory Board. This Supervisory Board functions as the supervisor of the Islamic insurance activities run by that particular company to ensure that all these insurance activities operate in accordance with the Divine Principles. For instance, the Malaysian takaful operation is supervised by a Shari'ah Supervisory Council by virtue of section (5)(b) of the Takaful Act 1984. In Sudan, moreover, there is a Shari'ah Supervisory Board that supervises, inter alia, insurance business in the country and which also passed the Rules of the Shari'ah Supervisory Board published by the Faisal Islamic Bank of Sudan.

14 See Chapters 2 and 3 of this book for a discussion of the contractual bases of takaful operations.

15 For Muslims, mutual cooperation among the parties in an insurance policy has been justified by the divine principles of mutual cooperation, solidarity, and brotherhood. Allah commanded: “… co-operate you one another in righteousness and piety” (al-Qu'ran, Surah al-Maidah, 5:3).

16 An insurance policy is based on the principles of rights and obligations arising from humanity and nature. For instance, it is logical and natural for every person in society to feel obliged to provide material security and protection as a right for themselves, their property, family, for the poor and helpless widows, and for children against unexpected perils and dangers. Such a natural obligation and right could well be justified by the following tradition of the Holy Prophet: “Narrated by Saad bin Abi Waqas … the Holy Prophet said. it is better for you to leave your offspring wealthy than to leave them poor asking others for help …” (Sahih al-Bukhari, Kitabul Adab, op. cit., Vol. 8, No. 725, pp. 477ff).

The Holy Prophet had also emphasized the importance of providing material security for widows and poor dependents in the following tradition: “Narrated by Safwan bin Salim, the Holy Prophet (s.a.w.) said: The one who looks after and works for a widow and a poor person, is like a warrior fighting for Allah's cause or like a person who fasts during the day and prays all the night …” (Id, Kitabul Adab, No. 35, p. 23).

17 It is one of the purposes of humanitarian law to inculcate mutual understanding in the community, to protect one against unexpected loss, damage, or other forms of risks or hardships. Hence, an insurance policy contributes toward alleviating hardships from a person arising from unexpected material risks, which is of course within the scope of the principles of humanitarian law.

18 “An Approach to Risk-based Market Conduct Regulation,” a report prepared by the Canadian Council of Insurance Regulators (CCIR) Risk-Based Market Conduct Regulation Committee for discussion, January 2008.