Supervisory Issues in Takaful: An Overview
The International Association of Insurance Supervisors in its 2005 paper “A New Framework for Insurance Supervision”1 sets out an overarching framework for supervision, which articulates the relationship between the different elements of supervision. It says:
… the Framework for insurance supervision consists of three groups of issues: financial issues, governance issues, and market conduct issues. It also encapsulates three levels or aspects in relation to these issues, reflecting three different responsibilities: preconditions for effective insurance supervision, regulatory requirements, and supervisory action.
The preconditions for effective insurance supervision cover such issues as an institutional and legal framework for the financial sector, efficient financial markets, and the existence of a supervisory authority with operational independence and adequate powers and resources.
“Supported by these preconditions, the Framework consists of three broadly defined categories or ‘blocks’ of issues, which relate to:
- the financial aspects of an insurer's operations
- how an insurer is governed
- how an insurer conducts its business and presents itself in the market.
Each of these blocks may be viewed from two main standpoints or aspects:
- regulatory requirements, which are addressed to the operations of the insurer
- supervisory action, which has regard to the responsibilities and activities of the supervisory authority.
Adherence by insurers to [regulatory] requirements needs to be subject to supervisory review. Assessment of an insurer's risk profile, controls and available support are also integral to supervisory reviews. Supervisors must assess individual insurers, taking into account the specific circumstances of each insurer. More specifically, the supervisor will need to tailor its review, and any remedial action taken, to the risk profile and specificities of each insurer, with due regard to the principles of legal certainty and equal treatment.
The contents of each of the elements of the Framework are interdependent; to keep the Framework stable and effective, less stringent requirements in one element imply a need for stronger measures in the others. However, a minimum level of coverage of each Framework element needs to be determined at a sufficiently exacting and granular level and agreed upon as an internationally acceptable standard. This combination of minimum coverage with compensating interdependence provides a solid overall framework.”
This general approach to insurance supervision, and this understanding of the components of an effective regime, are equally applicable to takaful, and they underpin the approach taken in this chapter. The key components of such a regime are set out in the IAIS's Insurance Core Principles2 to which reference will be made from time to time. In particular, this chapter assumes the existence of an effective supervisory body with operational independence, competent staff, and an appropriate range of powers. While this cannot yet be taken for granted in all jurisdictions, where it does not exist the problems go well beyond those specific to takaful.
The chapter also assumes that a minimum standard of regulatory provisions will be in place, whether in primary law, subordinate legislation, or rules made by the regulator. The content of these provisions is largely covered in other chapters of this book.
However, the distinction between regulatory provisions and supervisory action is not a hard line. As the IAIS makes clear, there is an interdependence between regulatory and supervisory activity. Supervisory activity is founded in the regulatory regime, but there are also areas of choice between stronger, and usually more prescriptive, regulatory requirements, and more active involvement by the supervisor. One manifestation of this is that where the regulatory regime is weak, the deficiencies may need to be filled by supervisory action. However, regimes that are strong but principles-based also require strong supervision, because of the elements of judgment and flexibility they contain.
Another reason why the line cannot be hard is that many, perhaps most, supervisory authorities are also to some extent regulators. Some have extensive rule-making powers, or the ability to propose rules to some other body. Even where the formal rules can be changed only with difficulty, a supervisor can often issue guidance or some other provisions with, if not mandatory, then strongly persuasive status. The supervisor may also have power to waive or modify rules in relation to particular businesses. So in practical terms, supervisory authorities will typically be considering a mixture of options to address an issue, some of them being regulatory or quasi-regulatory changes.
This chapter will, therefore, focus on the principal risks as seen by a supervisor, in the three areas identified by the IAIS, and concentrating on those that are wholly or partly specific to takaful. It will discuss ways in which these may be addressed, and the choice of regulatory tools, recognizing that some of the risks will be treated in more detail in other chapters.
In the case of takaful, the governance issues are primary, taking governance in the widest sense, to embrace the rights and obligations of the various parties, and the structures that balance and safeguard these. One reason for this is that the rights and obligations are much less well understood than in conventional insurance, with its longer history and substantial body of both statute and case law.
The more important reason is that, while there remain some pure mutuals, the common business model in the modern takaful industry is essentially a hybrid between a commercial shareholder company and a mutual. As discussed in Chapter 2, the exact nature of that hybridity, and the formal contractual relationships between the parties, may vary considerably. However, conceptually the takaful operator is acting on behalf of the participants (policyholders), whether as wakeel, or mudarib, or both. This throws up many of the problems of agency that are familiar in other areas of business, with the difference that the “agent” may be exposing significant amounts of its own capital.
But in addition to the takaful-specific issues, there remain those of governance more generally, including misalignment of the interests of management with those of owners and other stakeholders. So, the governance problems of takaful, as discussed in Chapter 4, are much more complex than in a normal shareholder or mutual company, with shareholder, policyholder, and management interests needing to be considered, while preserving observance of the Shari'ah.
It is perhaps worth noting also that governance issues are among the most difficult with which supervisors have to deal. At the regulatory level, it is difficult to specify governance arrangements that will be appropriate for the whole range of companies with which a supervisor has to deal. Furthermore, while it is relatively easy to ensure that formal structures of governance are present, it is much harder to ensure that they work effectively, especially under pressure. Many of these structures are intended to provide balance and challenge. This implies that there will be actual or potential conflicts, typically among highly motivated and highly intelligent individuals. Such individuals will attempt to bypass the governance structures or to bend them to their will, and this will not always be easy to detect. In addition, while a supervisor may apply standards of fitness and propriety, including competence, to board members and senior managers, it will usually require reasonable objective grounds for any disqualification. It would, for example, be difficult in practice to disqualify someone from a company board simply on the basis that he or she is no longer providing effective challenge to the chief executive.
So, in dealing with governance matters, supervisors are typically operating within a relatively non-prescriptive regulatory framework, needing to exercise considerable judgment about how effective the arrangements are within a given company, and often finding it difficult to apply regulatory tools in a way that will directly bear on the issue of governance.
For a supervisor, the key governance risks specific to takaful are failures of Shari'ah governance, that the contractual arrangements between policyholders and shareholders will create too great a misalignment of interests, and that the interests of policyholders will not be given adequate consideration in decision making.
The first of these risks is familiar from other areas of Islamic finance, and the risk mitigants are equally familiar. They would typically involve a requirement for formal Shari'ah advice from competent and independent scholars, for systems to implement that advice, and for Shari'ah review and audit. The functioning of systems like these will normally leave substantial documentary records, and will, therefore, be relatively easy for supervisors to evaluate during on-site visits.
A slightly more difficult, but equally familiar, issue is that of conflicts of interest, especially where scholars sit on the boards of companies that may be competitors, or counterparties to a given transaction (for example, a takaful undertaking and a retakaful undertaking with which it transacts). The possibility of conflicts can never be entirely avoided, and mechanisms need to be in place to manage them. The effective operation of these mechanisms is another area of supervisory interest.
In the case of takaful specifically, there are two main issues that need to be signaled. One familiar issue concerns the scope for differences between firms in the substance of the advice they receive. This is exacerbated where firms operate across national boundaries, since any attempt to secure uniformity of interpretation at the national level carries the risk that the firm will be subject to conflicting interpretations in the different countries in which it operates. Insurance is typically an international business. It depends on the law of large numbers to create diversified risk pools with sufficiently predictable behavior. Even where firms (in the sense of legal entities) are restricted to a particular country, they may well be parts of international groups where the risks are pooled through intra-group transactions. Thus, takaful firms and groups may be more exposed to differences in Shari'ah interpretation than some other types of business. This is further exacerbated by the fact that, since takaful is a relatively young industry, interpretations have not yet settled. At almost any serious meeting on the subject, important differences will be aired, and views may be quite passionate.
The other issue is that, in a situation where shortage of Shari'ah scholars with adequate financial knowledge is an issue for much of Islamic finance, the number with competence in insurance is likely to be even smaller. While this may have some beneficial impact on the diversity of interpretations, it increases the risks of conflicts of interest, as scholars are more likely to sit on the boards of companies who compete, or do business, with each other.
There is relatively little that supervisors can do directly about these issues. Depending on their approach to Shari'ah governance, they will need to consider carefully any arguments for a firm to follow the interpretations current in its parent country. They will also, as mentioned above, need to face the fact that conflicts of interest among scholars cannot be entirely avoided, but certainly need to be appropriately managed.
The second risk—of a misalignment of interest arising from the contractual arrangements—is more difficult. Even where undertakings use the same basic Islamic contracts to define the relationships, the detail of the contracts may vary in ways that materially affect incentives. For example, in general takaful, if the operator receives a wakalah fee calculated as a flat percentage of contributions, the operator will have an incentive to maximize premium volume, even at the risk of writing uneconomic business—especially if there is no effective obligation to provide qard if the takaful fund is in deficit. If, on the other hand, the wakalah fee includes a substantial element related to the performance of the takaful fund, depending on how “performance” is defined and measured, the operator may have an incentive to maximize the surplus in the fund. This would be likely to involve writing a smaller amount of business at higher rates. Where mudarabah-based models are used for investment management, the fact that (absent misconduct or negligence) the mudarib participates in profits but not in losses would naturally lead the operator to display a greater risk appetite than contributors.
There are also conflicts in investment management that flow immediately from the fact that, in a typical modern takaful operation, there are at least two pools of capital with different ownership—shareholders and policyholders. Indeed, there may be more than two pools if the operator chooses to separate classes of policyholder—for example, short-tail from long-tail business. This immediately creates a set of potential conflicts in the management of the undertaking's investments, which must be attributed to policyholders, to shareholders, or to both in some defined proportion. The fact that there may be different risk appetites between the two pools, and different considerations of asset–liability matching, means that simplistic approaches will not work.
Thus, in a takaful insurer, the issues of protection of policyholders' interests are even greater than in most conventional insurers. Even in a conventional insurer, they can prove intractable. The classic U.K. approach for life business was to give an “appointed actuary” a protective role going beyond the purely technical, a model imitated by several other countries. This model has some attractions, whether for conventional or takaful business; but it also has its limitations. The role of the appointed actuary within the company has always rendered him or her liable to “capture,” so that he or she becomes no different in thinking from any other member of management. Indeed, the greater his or her influence in decision making, the greater that risk may become.
It is worth noting that even pure mutuals can suffer from governance problems. It is difficult for policyholders in a large mutual to influence management effectively, and also for them to make sound judgments about their long-term interests in a highly technical area. The British mutual Equitable Life suffered major problems that led to the British government's setting up an inquiry led by Lord Penrose.3 Lord Penrose, a judge, criticized the firm's corporate governance and commented on the failure of the “appointed actuary” to protect policyholders' interests. He said:
There is no external interest that can be relied upon to protect the interests of policyholders of a mutual life office, and the policyholders, though representing the proprietary interest in the organization, are powerless. … I have come to the view that the only acceptable approach to the many, and unpredictable, issues that are peculiar to the mutual life office is to ensure that they are subject to a degree of regulatory scrutiny that takes account of the reality that, apart from the regulator, there is no-one who can intervene effectively to influence the activities of what must remain a form of organization managed by a self-perpetuating oligarchy, selected on an unaccountable basis by current directors as their successors in office, and vulnerable to the influence and, in an extreme case, control of professional actuaries who are answerable, if at all, only to those same directors who are fundamentally dependent on their advice.
With few changes, this argument can be applied also to the governance of a takaful operator.
No regulator can be practically involved with every significant business decision. To try to do so, especially with limited information and resources, creates hazard for both regulator and regulated. The approach to governance in a takaful operator, therefore, needs to provide a mechanism by which policyholder interests can be continuously represented in decision making. (One mechanism, practiced in Sudan, is discussed in Chapter 4.) The regulatory approach also needs to ensure that this mechanism is embedded within the firm, and to provide regular checks that it is, in fact, providing effective challenge. This is akin to the approach that some regulators take in relation to Shari'ah governance, with a heavy emphasis on the systems to ensure that Shari'ah rulings are implemented and that this is verified through audit. At the time of writing, the Islamic Financial Services Board is preparing a draft standard on the governance of takaful operators, which will propose a Governance Committee, as has already been proposed for other Islamic financial services firms. It is likely, however, to be some years before this (assuming it is finally adopted as a standard) is implemented across the majority of relevant jurisdictions. In the interim, supervisors will be faced with a more difficult task in trying to understand how the interests of policyholders are given proper weight across the undertaking—and to intervene, if this is not done appropriately.
7.2.1 A Note on Windows
The governance issues would be hugely magnified if the supervisor were to allow an insurer to establish a takaful “window.” (This term here means a window in the strictest sense, implying that both takaful and conventional policies are written within the same legal entity. The arguments do not apply with similar force to a dedicated takaful subsidiary, nor indeed to a window in an insurance intermediary.)
The existence of a window has several implications. There are now (at least) two separate groups of policyholders, as well as shareholders and managers, whose interests need to be balanced. Furthermore, it is very arguable that in such a situation the shareholders' funds (from which any loan to support the participants' risk account (PRA) must come) need to be invested in Shari'ah-compliant assets. The next question is whether funds originating from non-takaful policyholders are also invested in Shari'ah-compliant assets. If so, then the only material difference between them and takaful policyholders is that they do not participate in any surplus (and presumably pay lower premiums in consequence). But if the funds originating from those policyholders are not invested in Shari'ah-compliant assets, then they must be segregated from those of both the takaful policyholders and the shareholders. Arguably, the resulting structure would be, in effect, a conventional window within a takaful insurer.
If the assets of the conventional policyholders are commingled with those of the shareholders, then they may be called upon to support the PRA in the event of deficit, but the funds in the PRA are not available to support the conventional policyholders. This asymmetry is of concern as a matter of equity, and also raises issues about how any capital adequacy regime is to be applied.
If, on the other hand, funds emanating from conventional policyholders are managed as a separate pool, then the relationship between those and shareholders' funds needs to be defined, for capital adequacy purposes if for no other; the relevant incentives need to be understood; and, when investments come to be made, the interests of all three groups of parties need to be balanced. It is difficult to see why anyone, insurer or supervisor, who has fully considered these issues would opt for a window structure rather than a subsidiary.
The one possible exception lies in family takaful, where it is possible to conceive of a structure where takaful and non-takaful policyholders use a common PRA, and the assets of both this and the shareholders are invested in a Shari'ah-compliant way. However, they might have separate PIAs, following Shari'ah-compliant and non-compliant strategies, respectively. Such a structure of course depends on the assumption that PIA funds are never available to meet deficits in the PRA, and it remains difficult to see why it would be chosen over simpler structures.
Many—but by no means all—of the financial issues in a takaful operator are parallel to those in a conventional insurance company. Conversely, many of the strains that takaful undertakings experience in their dealings with their supervisors stem from fundamental weaknesses in the insurance regimes of their jurisdictions more generally.
At the time of writing, there is no generally accepted international standard for capital adequacy in insurance. In this respect, insurance differs fundamentally from banking, where the original Basel Accord (Basel I) achieved very wide acceptance. It was applied well beyond its original target of internationally active banks and, in some jurisdictions, well beyond the banking sector more generally. There can be few reputable jurisdictions that do not at least purport to apply the Basel Accord in either its first or second version for the majority of banking activity.
In contrast, insurance regimes have developed in a much more piecemeal fashion, and there is no generally accepted standard. The U.S. regime, for example, looks materially different from the Canadian or Australian one, and there remain countries that have no capital adequacy regime beyond bare solvency. The regime with the widest application is that of the European Union, but it has been accepted for some time that this regime has numerous weaknesses, including the absence of a risk-based approach to the asset side of the balance sheet. Fortunately, the EU's Solvency II program is now at an advanced stage, and is expected to deliver a state-of-the-art regime. The work is being done in close cooperation with a parallel project by the IAIS, and both projects are adopting principles broadly similar to those of Basel II. It will, however, be some years before these new regimes are in operation.
The progress toward a common regime has been hindered by lack of consensus on the valuation of assets and liabilities. Some regulators have traditionally favored highly prudent valuations. Others have preferred something closer to fair value, implying a need for greater explicit margins within the capital adequacy regime. There are in any event fundamental problems of valuation on the liability side, which have delayed the production of a definitive international accounting standard. (See, for example, “Preliminary Views on Insurance Contracts,” International Accounting Standards Board, May 2007.)
The main import of all this is that, even in conventional insurance, convergence on an advanced capital adequacy scheme is some way off, though the broad lines of such a scheme can now be discerned. We cannot expect the regulation of takaful to run ahead of insurance regulation more generally, though we can reasonably expect it not to lag far behind. Where the jurisdiction also allows conventional insurance, as most do, we can also expect the two frameworks to be very closely parallel; for them to be otherwise invites regulatory arbitrage.
It follows that the base assumption, in considering capital adequacy for takaful, should be the existence or availability of an insurance framework in line with good practice (though not necessarily best practice) elsewhere. But there is no single framework that can be assumed.
It is acknowledged that in some countries where takaful is practiced, this condition is not met, and the framework lags well behind even the reasonably good practice represented by the current European regime. In this situation, however, the problems of insurance regulation go beyond the scope of this chapter.
Assuming such a framework, what are the problems specific to takaful?
The first is the most basic one of identifying the entity or entities to which a prudential regime should be applied. This involves identifying which assets are available to meet which liabilities.
Within the normal structure of a modern takaful operation, a natural starting point is to consider the takaful fund (or participants' risk account). However, to consider this alone would imply taking no account of shareholders' funds. This, in turn, would imply that the PRA would need to be, and remain, adequately resourced on its own to support the early growth and development of the business. This is a difficult requirement to sustain within any reasonable business model.
The second option is to consider the legal entity as a whole, implying that all the assets of the entity are available to meet all its liabilities, including the claims of policyholders. The further implication of this is that there is an enforceable obligation for any deficit in the PRA to be made good from shareholders' funds. This could come from a regulatory requirement to offer qard, or from a legal view that there is a single entity involved against which any claim must lie and that a court would not enforce a separation between policyholders' and shareholders' funds.
A cautious regulator might well apply tests at both levels. If it did not do so, then the supervisor should certainly consider both levels when assessing risk.
A further complication enters when considering family takaful business which has a major savings element, and for which investment returns are, therefore, very important. In the operating structure commonly used in some countries, there is a segregation between the risk pool (the PRA) and a participants' investment account (PIA), which is used for the main investment element. (Although the funds in the PIA are pooled, they can be considered as separately attributable to each policyholder, and an account is normally kept on this basis.) It is common ground that, in principle, funds in the PIA should not be considered as available to meet any deficit in the PRA, or at least should rank behind shareholders' funds in so doing. The implication is that they should then be excluded from any capital adequacy calculation. If the regulatory regime does not achieve this, supervisors should certainly perform a calculation excluding them.
In this scenario, however, there is a question whether there exists any analogue to the well-known concept of displaced commercial risk in Islamic banking. That is, whether a takaful operator might feel commercial pressure to maintain returns to policyholders above the level justified by the performance of the underlying investments. If so, it would be wrong to exclude PIAs entirely from considerations of capital adequacy. This is an issue that does not appear to have been addressed specifically in any capital adequacy regime or in any standards-setting activity. Were the issue thought to be a real one, it would also be a matter for debate whether PIAs should be brought formally within the capital adequacy calculation or whether the possible existence of displaced commercial risk is simply a matter for supervisory vigilance.
The second major issue in prudential supervision concerns asset risk, bearing in mind the relatively limited choice of assets available to a takaful operator. This is of course a major issue in jurisdictions where the regulator is prescriptive on asset allocation, but may still raise problems in even the most advanced environments.
There remains a shortage of fixed (or quasi-fixed) return instruments available for investment, particularly at the longer maturities, thus giving rise to potential asset/liability mismatches. Because of this shortage, sukuk, in particular, tend to have no deep and liquid market, giving rise to issues of valuation. Real estate may be a tempting longer-term investment, but besides being a highly cyclical asset class, it notoriously lacks liquidity.
In practice, existing takaful insurers have tended to take a cautious approach and to place their investments in short-term instruments, particularly in accounts with Islamic banks. This generally cautious approach has led to investment returns that have tended to be below those of conventional insurers, which puts commercial strain on the undertaking, but at least of a kind that is relatively manageable by supervisors.
The current pattern of investment by takaful undertakings reflects the concentration of the business in non-life personal lines, which tend to be short-tail. The pattern will, of course, be different for the longer durations associated with family takaful, especially where an investment component is an explicit part of the offering. In these circumstances, one would expect the equities component of the investments to be increased (either directly or through investment funds), but the explicit bearing of investment risk by policyholders limits (though it does not eliminate) the problems of volatility in equity markets. Some non-life commercial lines, however, have substantially longer tails than personal lines, and if takaful expands beyond its personal lines niche, this may give rise to significant problems on the asset side.
So far, this discussion of asset risk has been concerned with the risks associated with individual investments, and with asset/liability matching. There are, however, aspects of concentration risk that are particularly likely to afflict takaful undertakings, even beyond the straightforward one stemming from a limited choice of investments.
The first is that these undertakings are commonly part of wider financial groups, and research (discussed in Chapter 11) has shown a tendency for investments to be concentrated with other members of the same group. This creates both a straightforward concentration risk and group risk (that is, the risk that problems in one part of the group will have knock-on effects on other parts, or that common problems will make it difficult for group members to support each other in case of necessity).
The second derives from a category of assets not yet discussed, the reinsurance receivables. Most takaful undertakings are small, and have high cession rates, typically around 50 percent. This implies that a well-designed reinsurance program is a necessity, and that this should avoid over-concentration on a single reinsurer (or retakaful operator). The quality of a reinsurance program is a matter for supervisory judgment, since the circumstances of primary takaful companies will vary too much for the structure to be prescribed in rules. (It is also worth noting that, even with a well-designed program, concentration may arise if a high-severity event produces a large claim against a single reinsurer.)
More generally, the supervisory approach to asset-side problems will depend on the nature of the capital regime. In fully risk-based systems, many of the issues described above will be reflected automatically in capital requirements. Where they are not, supervisors will need to be more alert in their assessments of the risks run by particular firms. This will be necessary in any event in relation to those risks that are difficult to reflect in formal capital regimes, such as asset/liability mismatches. Supervisors will also need to be sure that the firm has proper systems and controls in relation to its investment decisions, and that these are working in practice. These systems should certainly cover the various forms of asset/liability matching, as well as the avoidance of concentration and group risk.
7.3.1 Group Supervision
Insurance regulators have, in general, lagged behind banking regulators in supervising groups of companies on a consolidated basis, tending instead to concentrate on ring-fencing their local operations. This is changing, and group supervision in some form is likely to be part of the future landscape of insurance regulation.
For takaful groups, most of the issues will be those which apply at the individual undertaking level, and which have already been discussed. The principal technical issue will be exactly how consolidation should take place—in particular, how far both shareholders' and policyholders' funds should be aggregated at group level. Underlying this, however, is a fundamental question of principle, which is whether the funds in a PRA in one takaful undertaking can be considered to be in any sense available to meet obligations arising in other takaful undertakings. These funds are, of course, considered to be those of the contributors, donated to compensate other contributors in the event of defined adversities. The question is then how widely the intent of that donation can be construed. This is an answer that, so far as the present writer is aware, has never been fully addressed as a matter of principle. However, individual takaful undertakings may have addressed it in their policy documents, thus restricting by contract the right of the operator to transfer surpluses on one fund to cover deficits on another within the same undertaking.
Where the takaful operator is part of a group that contains conventional insurers, the issue may become even sharper if it has not been addressed as a matter of contract.
Takaful operators may also be parts of financial groups that contain non-insurance operations. There are well-established principles on the supervision of financial conglomerates, deriving mainly from the work of the Joint Forum, though supervisory practice often lags behind the principles. The integration of even conventional insurance into financial group consolidation can be difficult, because the approaches to insurance risk are necessarily different from those to the other areas of risk in such conglomerates. In the case of takaful undertakings, the issue set out in the previous paragraph will further complicate the issue. In the absence of any specific contractual provision, it is conceivable that the intentions of takaful policyholders might possibly be construed to allow their premium contributions (being donations) to be regarded as available to meet takaful liabilities elsewhere. However, it is very hard to see that they could be regarded as available to meet liabilities arising from, say, banking or equities operations.
There is no simple, mechanical answer to the problems of group supervision for takaful, at least in the present state of maturity of the industry. The only conclusion that can be drawn is that supervisors need to apply group consolidation techniques with care, and to consider not only the outcome of a calculation but also the actual risks arising within the group and the resources that are available to meet these.
7.3.2 Disclosures to the Market
Part of prudential supervision is disclosure to the financial markets. In banking, this would be Pillar 3 of the Basel Accord. This disclosure needs to be distinguished from disclosures to customers or prospective customers, which are normally regarded as part of market conduct supervision.
In the words of a key IAIS paper:4
When provided with appropriate information that allows them to assess an insurer's activities and the risks inherent in those activities, markets can act efficiently, rewarding those companies that manage risk effectively and penalizing those that do not. This is often referred to as market discipline. It serves as an adjunct to supervision.
Individual policyholders do not always have the ability or resources to assess insurers' financial stability and understand insurer disclosures … [O]ther market participants, such as shareholders, equity analysts, insurance agents and brokers, rating agencies, and the news media help individual policyholders monitor insurer activities; albeit, their role and involvement varies both by country and within country by type of insurance product.
The concept is that disclosures will affect not only the behavior of policyholders and potential policyholders, but also that of investors, lenders, and market counterparties in ways that impose discipline on the firm. Such concepts, in both insurance and banking, lead to regulators specifying disclosures which go well beyond those that would be made by a normal trading company.
The IAIS has promulgated standards for enhanced disclosures in various areas,5 and it is intended that these will be integrated into a single disclosure standard. At the time of writing, these have not been generally adopted even in advanced jurisdictions, and it is probable that adoption will be linked to that of new capital adequacy regimes of the kind already mentioned.
These disclosures have been formulated with normal shareholder companies primarily in mind. They will need significant adaptation for typical takaful structures if they are not to mislead, because of the need to respect the division between policyholders' and shareholders' funds, and more fundamentally because of the different way in which takaful allocates risk between the parties. It will, of course, be the responsibility of the supervisor to ensure that the prescribed disclosures are made, and that this is done in a way that is clear, fair, and not misleading.
7.3.3 A Note on Insolvency
The insolvency of an insurer, whether conventional or takaful is, of course, a circumstance that all supervisors wish to avoid. Furthermore, although in some jurisdictions an insolvency or potential insolvency will be overseen by the supervisory authority, in others, the process will be overseen by the courts, with a minimal role for the supervisor. Insurance insolvency law is a particularly arcane branch of what is already a highly specialized subject, and it would be inappropriate to discuss it in detail here, especially since to the best of this writer's knowledge, no takaful undertaking has ever entered insolvency.
It is, however, insolvency that will place the relationships within a takaful undertaking under the sharpest scrutiny. In particular, given that a takaful undertaking is constituted as a single legal entity, it remains to be seen to what extent a court will maintain the separation between shareholders' funds, PRA, and PIA. At one extreme, it could hold that the undertaking is a single entity and that, for example, the assets of the PRA and/or PIA are fully available to pay creditors of the shareholders. At the other extreme, it could hold that separation is absolute and that there is no obligation on the shareholders to support any deficit in the PRA if that would impact adversely on their own creditors. (Note, however, that this would run counter to the position in Europe that policyholders' claims should be preferred over the general claims against an insurance company.)
It would not be fruitful to speculate in detail on how a court might behave, especially since courts in different jurisdictions might behave differently. The fundamental point for supervisors is that, in considering capital adequacy, they should not regard particular assets as available to meet particular liabilities unless they have a reasonable basis to believe that this position would be sustained in that ultimate test.
7.3.4 A Note on Run-off
Run-off, the circumstance where an insurer has ceased to write new business but continues to pay claims, is one of the most difficult circumstances for an insurance supervisor, because it changes fundamentally the structure of incentives.
In conventional general insurance, with no prospect of new business, the shareholders have no incentive to pay claims where they can possibly avoid doing so (though this may be mitigated if there are companies in the same group whose reputation would suffer). They also have no incentive to maintain capital beyond the absolute minimum required by law, and every incentive to extract capital where possible. Besides the usual ways of extracting capital, typically by dividends, techniques such as management fees or reinsurance placements with associated companies can be used. Encouraging forecasts of claims development may be used to support the extraction of capital, and when these prove unfounded, there may be insufficient money available to pay policyholder claims. At the same time, the sanctions available to supervisors are reduced, since a threat to revoke the firm's licence would be entirely empty, and possibly counterproductive.
All this leads supervisors to take an intense interest in a firm in run-off, and generally to subject it to a special regime designed to constrain the extraction of capital.
More positively, in recent years, there has grown up a specialist industry which manages business in run-off, which runs the business economically but with integrity, and which hopes to close the run-off leaving capital in the firm to which it will then be entitled.
For general takaful, however, the position is fundamentally different, at least within the most common model. Once new business ceases to be written, the flow of wakalah fees into shareholders' funds also ceases. Yet the expenses of managing the business continue, albeit reduced by the fact that no new business is being acquired. Although there may be a continuing mudarib share from the management of investments, it is likely that the costs of running off the business to finality will represent a continuing erosion of shareholders' equity. On the other hand, the funds in the PRA are the property of the policyholders and, while this removes the incentive to restrict claims payments, it also means that the shareholders have no prospect of gain by managing the run-off successfully. This creates an unusually powerful set of incentives for shareholders to extract as much capital as possible and walk away, while making it much less attractive for a reputable run-off specialist to take on the business. It is likely that some new basis of contract would need to be established between the policyholders and a run-off manager, but it is far from easy to see how this might be achieved. It is possible that a way might need to be found for either the supervisor or a court to act for the policyholders in reaching this point. In any event, the (even) greater level of temptation to extract capital, leaving policyholders potentially at risk, will require still stronger supervisory oversight than in a conventional insurer.
The issues in conventional life assurance, and in family takaful, are significantly different. Here the principal remaining activity is investment management, and the risks of adverse developments on—mainly mortality—claims are a less prominent issue. In takaful, the continuing flow of premium installments on existing policies and, especially, continuing mudarabah profit sharing on investments should offer adequate incentives to shareholders, or to a new run-off specialist, to manage the business.
This term—or its counterpart, “conduct of business”—refers primarily to the way an insurer deals with its policyholders or prospective policyholders, whether directly or through intermediaries. It also covers its dealings with other market players—for example, intermediaries or investment managers—and its behavior as an investor—for example, the avoidance of market manipulation. In these latter areas, however, it is difficult to see that there are issues for supervisors that are different in any material way from those applying to conventional insurers. This section, therefore, concentrates on behavior toward policyholders.
The principal, but not the only, issues here concern the point of sale. Here, it should be noted from the outset that, for conventional insurance, the strength of market conduct regimes varies from jurisdiction to jurisdiction even more than that of capital adequacy regimes. There are also, rightly, differences between the regimes applying to general and life products (or at least those life products with a substantial investment element). The justification for this is mainly the long duration of these products together with generally low surrender values in the early years. This means that an unsuitable purchase cannot be unwound without significant loss. Nor is there, as with most general insurance, the opportunity to change suppliers at a reasonably short interval. In integrated regimes, it is likely that the market conduct regime for life assurance products will be substantially aligned with that for other investment products such as mutual funds.
Market conduct regimes are typically focused on the protection of retail consumers, though the actual definition of these may vary. Since takaful is dominantly a personal lines business, the discussion in this chapter will be confined to the retail area.
It should be noted, however, that even in advanced jurisdictions, the development of market conduct regimes for insurance has lagged behind the development of prudential regulation, and also behind market conduct regimes in other sectors, notably asset management. It is, therefore, even more difficult than in the area of capital adequacy to assume a single underlying pattern, or even a general intensity of regulation. This is especially the case in general insurance, and in the regulation of intermediaries.
The tools typically employed by market conduct regulators are regulation of contract terms and sometimes pricing (“rate and form”), disclosure requirements, and suitability. Detailed regulation of contract terms, requiring supervisors to scrutinize each new contract, is currently slipping from favor, because of the cost to both the supervisor and the supervised, and its adverse impact on innovation. In the European Community, it is unlawful, though there does exist legislation barring unfair terms of certain types.
The other two tools, disclosure and suitability, are very closely linked. The former broadly relies on providing information to the consumer, on the basis of which it is expected that he or she can make a good and informed choice. Suitability places the obligation on the firm to ensure that the product that is sold is suitable for the consumer, at least within some parameters. In recent years, disclosure has been the favored approach, based on the principle that consumers should be responsible for their own decisions and on the difficulty of supervising a suitability criterion, which inevitably depends on the circumstances of each client. More recently still, however, there appears to be a renewed emphasis on suitability, deriving from the difficulty of making all the disclosures that a consumer would need to make an informed decision, in a form that in practice will be read and understood.
As in the case of capital adequacy, this chapter will assume that a reasonably well-developed market conduct regime exists for conventional insurance, and that it may contain elements of product regulation, disclosure, and suitability. However, some of the issues mentioned in the previous paragraph will be recalled at later points in the discussion.
To the extent that product regulation is considered appropriate, the emphasis in Islamic finance on contract certainty and the avoidance of gharar is very helpful. There are unlikely to be any fundamental issues for supervisors. Supervisors will, however, need to have sufficient knowledge of takaful to be able to understand the products with which they are dealing, and the significant differences between takaful contracts and conventional ones. Of course, this assumes that any elements of product regulation are genuinely concerned with consumer protection and are not intended to restrict competition and innovation in the market. Were that to be the case, it would be fundamentally the introduction of new products that would be at issue, not the fact that these are takaful products.
Disclosure is a much more difficult area. There will certainly be additional disclosures that need to be made. At minimum, these will need to cover the contractual relationships between the takaful policyholders and the operator, including the circumstances (if any) in which additional contributions may be sought, and the basis for distribution of any surplus. In the case of family takaful, the structural disclosures will also need to cover the relationships governing the PIAs (where this structure is used), and whether there are circumstances in which PIA funds may be called upon to meet a deficit in the PRA. There will also need to be disclosures about the Shari'ah supervisory process; these will parallel the disclosures in other areas of Islamic finance, and do not need detailed discussion here.
These disclosures will be additional to those normally required for conventional insurance products of the type in question. Where these products are general insurance, the disclosures are likely to be limited to the terms of the insurance, especially the risks covered. For life assurance, especially investment products, one might expect required disclosures relating to investment strategy and risks, projected returns, and the terms of any early surrender or other termination of the policy.
Beyond specifying the substance of the disclosures, the main challenge for supervisors will be to ensure that the disclosures are made in a way that is comprehensible to consumers. In particular, and especially in jurisdictions where both conventional and takaful products are available, they will need to convey clearly the difference between takaful and conventional insurance.
The most significant problem will be that of comprehension. While it is possible to make, and to specify, any individual disclosure in a form comprehensible to even less sophisticated consumers, one should not underestimate the problems where multiple disclosures need to be made. It is very easy to end up with several pages of required disclosures which are neither read nor understood, and which do little to mitigate the fundamental risk of the consumer's buying an inappropriate product.
Indeed, the size of the disclosure obligations resulting when those for takaful are overlaid on to those for insurance generally could prove material in persuading regulators and supervisors to emphasize other regulatory tools.
By comparison, suitability is an easier regulatory tool to apply, at least when the product is sold by the takaful undertaking itself. In these circumstances, there is essentially no difference from applying a suitability criterion in conventional insurance.
The situation becomes a little more difficult, however, when the product is sold through an intermediary, especially if that intermediary also sells conventional products. Suitability will then require the intermediary to acquire and consider a wider set of information about the customer and his or her preferences than would be the case in a purely conventional environment. In particular, the intermediary will need to take into account the weight that the customer gives to issues of Shari'ah and, even for a non-Muslim client, the weight given to the other specific characteristics of takaful, such as the possibility of a return from surplus. The intermediary will also need to consider any differences in coverage, especially if Shari'ah principles lead a takaful operator to exclude circumstances that would normally be covered by a conventional insurer.
For a supervisor, indeed, the main market conduct problems in the takaful sector are likely to center on the use of intermediaries. We have noted above that the regulation of sales through intermediaries varies greatly from jurisdiction to jurisdiction. Some jurisdictions regulate intermediaries directly, some place the onus on the insurer, and others have scarcely any provisions. The weakest area of regulation is general insurance, and especially general insurance sold as incidental to another purchase, such as travel or a car. While product regulation can easily bear directly on the insurer, and disclosure regimes can operate by requiring insurers to take responsibility for ensuring that disclosures are made by their intermediaries, suitability regimes are very difficult to operate in this way, especially where the intermediary may be an agent for more than one insurer. With any plausible combination of regulatory tools, a supervisor who does not have responsibility for intermediaries will have difficulty in ensuring that consumers are not sold unsuitable products and, in particular, that their choices between takaful and conventional products are appropriate.
Even where intermediaries are directly regulated, supervision in this area is not trivial. Effective market conduct supervision always requires some consideration of actual outcomes, and therefore, review of individual cases. Where a suitability criterion is applied, supervisors need the competence to judge whether this criterion is met in individual cases, which implies a substantial degree of sophistication and knowledge. It should also be noted that many potential markets for takaful are ones in which bancassurance—that is, the use of banks as distribution channels for insurance products—is likely to be common. There is a risk that, where there is not an integrated financial services supervisor, these distribution channels may be supervised by people with limited familiarity with insurance products. This increases the risk of adverse outcomes, and might lead to placing more weight on disclosure (but subject always to the problems already outlined with a complex set of disclosures).
Although this discussion of market conduct has concentrated on the sale process, it is appropriate to discuss briefly the second most important area of market conduct for an insurer: the payment of claims. There are few issues here, because the risk coverage should have been defined with some precision in the original policy, and of course the normal insurance principle of utmost good faith will apply (and appears fully consistent with Shari'ah principles).
It has been suggested by some that there may be an issue over ex gratia payments, since the takaful operator may be tempted to make payments, in pursuit of goodwill and future business, ignoring the fact that the PRA from which such payments would be made belongs to the policyholders, not the shareholders. On the other hand, most supervisors would think it appropriate for an insurer to make ex gratia payments from time to time, essentially on compassionate grounds. This issue may, however, be more theoretical than practical. It could be articulated in almost identical language for a conventional mutual, given that in such a firm (as already discussed) the interests of management may diverge from those of policyholders. But there appears to be no evidence that these mutuals are generous in their ex gratia payments beyond a point with which their policyholders/owners would be content (nor, more generally, a perception that they are especially good payers of claims). The most appropriate approach to this issue is fortunately one that would be good practice for other reasons—that is, to expect a proper system of authorities to be in place for making claims decisions, along with documentation of the reasons for any unusual decisions, including ex gratia payments.
The analysis so far has focused primarily on those areas where the structures and principles of takaful are materially different from those of conventional insurers, though inevitably the relative novelty of takaful has also been relevant. There are, however, some supervisory considerations that arise from the current structure of the takaful marketplace (and which might, therefore, disappear were it to reach the state of maturity of conventional insurance).
One, which has already been alluded to, is that it is dominantly a personal lines business. The impact of this on market conduct has already been discussed. However, in the area of prudential regulation it is broadly helpful, since it means that long-tail general business—for example, product liability—is almost totally absent. Since this is the type of general business for which it is most difficult to provision, and which causes the greatest problems for supervisors, its absence simplifies supervision.
A less helpful feature of the industry is that it is characterized by relatively small companies which, naturally enough given their size, are highly dependent on reinsurance/retakaful. The effect of this on asset-side risk has already been discussed. It has other implications, however, in that companies of this kind are likely to have lower levels of technical expertise than their larger counterparts. In some areas, notably product design and underwriting, they may well place heavy reliance on their reinsurers. In others, however, there may be significant elements of weakness. These may include areas such as risk management and compliance on which supervisors might rightly focus.
The industry is also growing rapidly. Growth may take two forms: the establishment of new undertakings and the expansion of existing ones.
Where new undertakings are established, the supervisory authority's focus will normally be on the licensing process. The elements of a licensing process are well-known,6 and many of them have either been discussed above or are no different for a takaful undertaking compared to a conventional firm. There will, of course, need to be evaluation of the arrangements for Shari'ah governance, and the scrutiny of the firm's business plan may be more difficult than usual simply because there are more unknowns in takaful than in conventional markets. Note also that where the process of licensing is separated from that of ongoing supervision, as in some authorities, takaful expertise will be required in both parts of the organization.
The expansion of existing undertakings poses different issues. One is the management strain, and the pressure on competence at all levels, inevitably produced by any rapid expansion. A second is the financial strain, normally referred to as “new business strain,” which derives fundamentally from the fact that the costs of acquisition of new business may well exceed the revenues, especially in the early years. This tends to be a particular problem for life business (and, hence, family takaful), where commissions to intermediaries are related to the total premium expected from a long-term product, but are paid in the early years. The third is the internal new product approval process, which of course assumes particular importance in the context of rapid expansion. For takaful, this process will include that of Shari'ah approval, and the Shari'ah approval process may, therefore, come under particular test.
As regards intermediaries, a number of the issues concerned with distribution have been discussed. The issues of novelty and expansion are, however, relevant in this area too, with particular emphasis on the competence of customer-facing staff to advise on takaful products.
Finally, it is perhaps worth remarking that the development of a takaful market may also have impacts on the supervision of conventional insurers. The most obvious circumstance would be where the entry or expansion of takaful players exposes conventional insurers to greater competition, and thus, to financial pressures.
The overall priorities of a supervisor will, or at least should, be determined by that supervisor's assessment of risk, in the context of the authority's overall objectives. These objectives, of course, vary somewhat between authorities, and different authorities have different risk appetites.
Supervisory priorities will derive partly from the circumstances of individual firms. The analysis set out above has indicated where differences between takaful and conventional firms are likely to affect supervision. It has concentrated on the differences that are inherent to takaful, but has also referred to some which derive from the takaful market—in particular, its rapid expansion.
It would be easy to infer from this that it is the differences between takaful and conventional insurance that will dominate supervisory thinking. This may well be the case at the level of supervisory policy, as regulators grapple with new issues, assess risks, and determine what regulatory tools to use to mitigate them. At the individual firm level, however, many of the areas of risk will be similar as between takaful and conventional firms. The level of competence in a firm's underwriting function, for example, is a significant issue for a supervisor, but it does not flow directly from whether that firm is a conventional insurer or a takaful undertaking. Similar comments can be made about many areas of supervision, whether financial, governance, or market conduct. This is reinforced by the analysis conducted by the joint IFSB/IAIS Working Group,7 which analyzed the full set of Insurance Core Principles in detail and found relatively few areas at which any modification for takaful needed even to be considered. So supervision priorities at the individual firm level, and between firms, are likely to be modified rather than driven by the fact that some of those firms conduct takaful business.
Supervisory priorities, at both the policy and operational levels, will also be influenced by the nature of the market. Some market factors have been discussed above, with an emphasis on the dynamics of the takaful market. There will be other market factors, however, which are dependent on the circumstances of the individual jurisdiction. One example would be the nature of the distribution channels in that jurisdiction. Another would be the level of consumer sophistication in insurance matters, which will, in particular, affect the viability of disclosure as a primary regulatory tool in market conduct matters.
In addition, supervisory priorities will be driven by more transient circumstances. An obvious example would be a major fall in equity markets, which would naturally lead supervisors to focus on the prudential implications for those firms with a heavy exposure to equities. Another would be a natural disaster, exposing some firms to an unusually high level of claims.
Thus, the presence and development of takaful will be only one of the factors driving supervisory priorities. It will certainly have an impact at the policy level, but at the operational level, it will be one of many factors driving priorities.
7.6.1 A Note on Supervisory Competence
The competence of supervisory staff is, of course, critical to all good supervision. How are the requirements modified by the presence of takaful undertakings?
In a formal sense, the answer is: relatively little. Supervisors will, of course, need to understand the basic principles of takaful, how they are implemented in practice, and how Shari'ah supervision is undertaken. But it is not necessary for supervisors themselves to understand the deeper issues of Shari'ah that are sometimes raised (though they may need to have access to advice on these points, depending on how the supervisory authority conceives its role). The need for training should not be obscured, but it is difficult to believe that a supervisor with a solid grasp of conventional insurance would have fundamental difficulty in understanding takaful at a level sufficient to supervise it effectively.
In a practical sense, however, the demands on supervisory capability may be greater than this suggests. It is very likely that the regulatory regime for takaful will be to some extent inadequate, reflecting the relative novelty of takaful, the lack of international standards in this area, and the time taken to effect change in most regulatory regimes. The formal regime may, therefore, be less effective in capturing the risks than its conventional counterpart, and it will be for supervisors to do this, and to use those tools they have available to address them. Even where the regulatory regime has responded relatively rapidly and effectively, the fact that takaful is not identical to conventional insurance will still force supervisors to work in areas where the issues are not well-known and patterns of supervision well-established. They will need to think at a higher level, and this will require more capable and, in general, more experienced staff. The extent of this requirement will depend in part on the speed of the policy response, which itself will be linked to the speed of international standards development. However, given the rapid development of this industry, and the questions that still remain to be answered, it would be wise to assume the need for a higher level of capability for some years to come.
Notes
1 A New Framework for Insurance Supervision: Towards a Common Structure and Common Standards for the Assessment of Insurer Solvency (the “Framework”), International Association of Insurance Supervisors, October 2005.
2 Insurance Core Principles and Methodology, International Association of Insurance Supervisors, October 2003.
3 “Report of the Equitable Life Inquiry,” The Right Honourable Lord Penrose, March 8, 2004.
4 Guidance Paper on Public Disclosure by Insurers, International Association of Insurance Supervisors, January 2002.
5 Standard on Disclosures Concerning Technical Performance and Risks for Non-Life Insurers and Reinsurers, International Association of Insurance Supervisors, October 2004; Standard on Disclosures Concerning Investment Risks and Performance for Insurers and Reinsurers, International Association of Insurance Supervisors, October 2005; and Standard on Disclosures Concerning Technical Risks and Performance for Life Insurers, International Association of Insurance Supervisors, October 2006.
6 See, for example, Insurance Core Principles 6 and 7: Insurance Core Principles and Methodology, International Association of Insurance Supervisors, October 2003.
7 Issues in Regulation and Supervision of Takaful (Islamic Insurance), Islamic Financial Services Board and International Association of Insurance Supervisors, August 2006.