Chapter 12

Issues in Rating Takaful Companies

Andrew Murray1

12.1 INTRODUCTION

Credit ratings have been used by conventional insurance companies for many years as a way to demonstrate financial strength, enhance transparency, and, in some cases, as a benchmark for management purposes. As the takaful industry develops and increases in maturity, more and more takaful and retakaful firms are considering credit ratings for these reasons and to compete more effectively with conventional insurance companies. Fitch Ratings and a number of other rating agencies have published information setting out their methodology for assigning credit ratings to takaful firms and how this methodology is different from that used in a review of a conventional insurance company.

Although rating agencies generally work in a similar way, their approach toward takaful firms does differ to some extent as the agencies have varying degrees of focus on the sector, and in some cases, also differ in their choice of key rating factors. This chapter provides a brief background on credit ratings as well as the main issues that Fitch considers to be especially important in the rating of takaful companies. The chapter does not include all the details of the agency's rating methodology; these are included in the published documentation available on the agency's website. It should also be noted that these views do not necessarily coincide with those of other agencies.

For clarity in this chapter, we highlight the distinction between the takaful fund (which collects contributions from policyholders and pays claims), the takaful operator (which is the legal entity that administers the takaful fund or funds), and the takaful undertaking. We use the term “takaful undertaking” or “takaful firm” to refer to the combination of a takaful fund and takaful operator.

12.2 WHAT IS A CREDIT RATING?

Credit ratings provide an opinion on the relative ability of an entity or transaction to meet financial commitments and are generally published in the form of letter grades. Credit ratings express risk in relative rank order, which is to say they are ordinal measures of credit risk. Thus, they should be seen as broadly consistent indicators of relative vulnerability, rather than as predictive indicators of actual, cardinal default rates.

The rating scale is traditionally divided into two sections, “investment grade” and “speculative grade.” “Investment grade” ratings (international long-term: “AAA” to “BBB-”) indicate relatively low to moderate credit risk. “Speculative grade” categories (international long-term: “BB+” to “D”) signal either a higher level of credit risk or that a default has already occurred. Obligations that are highly rated are viewed as a lower credit risk than lower-rated obligations, but the ratings themselves are not intended to be predictive of a particular frequency of default or a percentage expected loss.

In addition to the “international scale” which is designed to allow the comparison of credit quality internationally, “national scale” ratings are also available for many developing countries. These national scale ratings rank companies relative to the best credit in a particular country (usually the government), and therefore, often allow a comparison of firms within a particular country on a more granular scale than would otherwise be the case.

12.3 TYPES OF CREDIT RATING

The most common type of rating for an insurance company and the most likely to be useful for a takaful firm is an Insurer Financial Strength (IFS) rating. This type of rating is aimed at insurance policyholders to help them gauge the financial strength of an insurance organization and to provide a guide as to the likelihood of an insurer being able to honor its financial commitments to this class of creditors. Although takaful firms' policyholders (sometimes referred to as “participants”) pay their premium contributions in the form of donations, and thus, have a somewhat different status from that of policyholders in a conventional mutual insurer (and one that is quite different from that of policyholders in a conventional proprietary insurer), the IFS rating concept can be applied directly to takaful participants who share many similar characteristics with conventional policyholders.

Like conventional policyholders, takaful participants expect a form of financial protection to be provided by the takaful firm, and are subject to potential credit risk should they need to make a claim or be due benefits. Given this risk, the independent view that is provided by rating agencies as to the financial security offered by a particular takaful firm may help to attract new participants and to reassure current ones. A credit rating is especially important in the case of takaful firms, given the variety of structural forms in existence, differing legal provisions between countries, limited transparency, and varying degrees of regulatory oversight.

In addition to being used by insurance policyholders, credit ratings are also widely used by investors to help assess the credit risk associated with financial instruments, including investments that comply with Shari'ah principles (sukuk). The use of credit ratings for these purposes is expected to be less common in the context of takaful firms in the near to medium term, although it may be important for some groups that offer takaful services. Other types of credit ratings also exist but are not expected to be significant for takaful firms.

12.3.1 Typical Ratings Process

Ratings are decided by a committee of experienced rating analysts based on information that is collected, analyzed, and presented to the committee by a lead analyst and a back-up analyst.

The information used for analysis generally incorporates information provided directly by the rated company in addition to relevant publicly available data. This information is considered by the committee based on published criteria.

The main rating issues, including the firm's strengths and weaknesses as well as relevant legal and regulatory factors, are generally summarized in a Credit Analysis report which is published on the agency's website.

12.4 CREDIT RATING BASICS

Credit rating analyses are based on an evaluation of the rated company's current financial position, as well as a prospective assessment of how its financial position may change in the future. The rating methodology, therefore, includes an assessment of both quantitative and qualitative factors, though the relative weightings of each can vary given the company's unique circumstances.

In the case of takaful, where so many permutations of both business model and legal environment exist, it is difficult to apply a formulaic approach to assessing credit quality: instead, Fitch takes a principle-based approach to reviewing credit quality based on relevant credit characteristics. The published methodology is, therefore, not designed to address the specific takaful model or legal circumstances of any particular country, but to give guidance as to the principles that the agency will apply in each case.

Fitch's IFS, debt, and sukuk ratings are based on a combination of the probability of default, as well as the recovery that would be expected in the event of a default. Ratings are, therefore, determined by carrying out a two-step process to assess each of these factors based on a published methodology. The probability of default is assessed by considering the qualitative and quantitative strengths and weaknesses of the firm—particularly the various categories noted below. An insurer's recovery given default is generally based on standard assumptions, although at low credit rating levels, this becomes a bespoke analysis based on the balance sheet and unique circumstances of the particular firm. However, the recovery given default does depend on the legal and regulatory environment in which the firm is operating and, in particular, whether policyholders have a priority claim on the assets of the takaful firm in the event of a winding up of the firm.

In brief, Fitch's review of an insurance company falls into the following categories.

Many of the rating factors to be considered for takaful or retakaful firms will be the same as those for conventional insurers/reinsurers. That said, there are important differences that do exist in the way that such firms need to be evaluated and the key issues to be considered. Some of the most important of these rating issues for takaful firms are considered in the next section.

12.5 KEY ISSUES FOR RATING TAKAFUL FIRMS

The key rating issues discussed below are as follows:

• business structure and effectiveness of the business model;
• corporate governance and management;
• legal and regulatory framework;
• products;
• capitalization and financial flexibility;
• interest-free loan (qard hasan);
• investments;
• reinsurance;
• profitability;
• risk management;
• regulation and accounting;
• ability to address the main challenges facing takaful firms;
• Shari'ah compliance;
• rating methodology issues; and
• other issues.

These topics are by no means a definitive account or complete listing of issues that would be considered by a rating committee, and readers who want to know more should read Fitch's published ratings criteria and its special report on the takaful industry.

12.5.1 Business Structure and Effective Business Model

The starting point for any rating has to be a good understanding of the way that the takaful firm is organized as shown in Figure 12.1. For example, it is critical to understand whether the takaful firm is run on a commercial basis (that is, the takaful operator is a stock company with shareholders who expect a return) or a non-commercial basis (that is, the business is entirely mutual and cooperative). Especially for commercial firms, it is also necessary to appreciate the way that profits are shared between takaful participants and the takaful operator. For example, the reward for the takaful operator can be either based on a fee (as in the case of wakalah) or a share of profits (under mudarabah). In some cases, a combination of the two is used with investment activities carried out under a mudarabah contract with underwriting activities undertaken as part of a wakalah contract. A rating agency needs to appreciate this reward structure and the fees charged in order to better understand the competitiveness and long-term viability of the operations.

Although the use of a wakalah fee as a basis for rewarding the takaful operator for underwriting activities seems more acceptable to a greater number of Shari'ah scholars than mudarabah, it can also be more challenging to generate an economic return for shareholders through a purely wakalah fee-based approach. This is especially true while many takaful firms remain relatively small, and therefore, have relatively few participants over which to spread their fixed costs. For this reason, an increasing number of firms have been using approaches such as “modified-wakalah,” which allows a performance-based element to be paid to the operator and helps to ensure an economic return for the operator's shareholders.2

12.5.2 Corporate Governance and Management

This book covers management and corporate governance issues in some detail, and these aspects are critical for rating agencies to review. This is as true for a conventional insurance enterprise as for a takaful firm, but the latter also has additional corporate governance considerations to take into account.

For example, insofar as there is a separation of assets between the takaful operator and the takaful fund, this can lead to heightened principal–agent challenges (that is, challenges arising from one party managing the interests of another where incentives are not fully aligned). Both wakalah and mudarabah contracts offer protection to the operator from downside risk and, in the absence of mitigating factors, could potentially encourage greater risk to be taken by the takaful operator than would be optimal for participants.

The agency will consider the degree to which incentives are aligned between parties and the effect that these incentives are liable to have on the actions of the operator. For example, the use of a wakalah contract based on contributions could encourage the takaful operator to try to focus on expanding contributions to the detriment of other factors such as the quality of business. There is also a significant difference in the incentives for the operator depending on whether the wakalah fee is based on net contributions (that is, after reinsurance purchases) or gross contributions (before reinsurance purchases). In addition, the mudarabah model in particular may encourage greater risks to be taken on behalf of the participants as the operator shares in the upside but may not necessarily suffer the negative consequences.

Clearly, where legislation or contract wording results in the operator's shareholders being exposed to risk (for example, through the winding-up regime or a compulsory, subordinated qard hasan), this helps to align incentives and reduce (although not eliminate) such corporate governance issues.

A further, noteworthy element of corporate governance relates to the composition of, and interaction between, the Shari'ah board and the board of directors. These are two influential bodies with different roles, but it is nevertheless necessary for them to communicate with each other to avoid potential conflicts. Each of the boards needs to have appropriate checks and balances so that they can be valuable forums for debate, rather than simply a notional construct designed to support the view of a single individual or group.

12.5.3 Legal and Regulatory Framework

Fitch regards the legal and regulatory framework as a key area for development in the takaful industry. A clear legal framework in each jurisdiction, together with certainty in the practical application of that framework, would add significantly to the protection offered to takaful participants, as well as enhance the ability of investors and participants to assess the risk associated with takaful firms.

The legal system used varies significantly between jurisdictions, especially as some countries operate a Shari'ah-based legal system (for example, Iran, Saudi Arabia, and Sudan), while others (for example, Malaysia and Bahrain) operate a dual legal system with Shari'ah-based laws operating alongside either common or civil law. In other countries such as the U.K. and France, Shari'ah plays no role in the legal process. Where more than one set of laws applies (legal pluralism), this can, in some cases, affect the certainty and predictability of legal transactions and procedures, especially as it affects Islamic finance and takaful.

There is also a wide divergence in the extent to which the legal and regulatory regimes of different countries address specific takaful issues, and while this is a general consideration with Islamic finance that can add to risk, it can also have an impact on legal certainty. This is an area where progress is currently being made: Malaysia is currently updating its Takaful Act of 1984, and recent advances have been made by countries such as Pakistan and Saudi Arabia. Fitch views positively explicit wording that helps to provide clarity over the legal and regulatory situation of takaful firms winding up, and encourages further development and clarity in this area.

When a non-commercial takaful business model is used which has a single pool of funds, legal issues are relatively straightforward and are similar to those that affect conventional mutual firms (for example, the priority of policyholders in the winding up of a firm). However, where participant assets are segregated from those of a service provider (that is, the takaful operator) such as in commercial takaful models, then the situation can become more complex. In such cases, clarity on the following areas is especially important.

• The extent to which the takaful operator and the takaful fund are legally considered separate in the event of a winding up of the business, as well as the extent to which participants have recourse to assets of the takaful operator in this scenario

  These factors determine the ability of the takaful participants to benefit from assets held outside of the participants' fund. In addition, the extent to which the takaful operator and takaful fund are viewed as separate entities affects the degree to which participant assets are protected from difficulties that could arise in the takaful operator.

• The circumstances (if any) under which an interest-free loan (qard hasan) is required from the operator to the fund and the triggers requiring the loan to be made

  The loan constitutes a mechanism by which assets can be transferred from the takaful operator to the takaful fund, and this can result in an indirect availability of the takaful operator's assets to the takaful funds.3

• The priority of the interest-free loan from the operator in the event of a winding up of the takaful firm

  Fitch would expect the regulations to require this loan to be generally subordinated to the takaful fund's obligations to participants (participant obligations).4

• The terms of repayment of the interest-free loan (for example, restrictions that repayment may be made only from future surpluses, with no set maturity)

  If no requirements are specified, then this reduces confidence that an existing loan from the operator will necessarily be in place when it is required.

• The status of different sub-funds within the participants' takaful fund

  To what extent are surpluses in one area able to compensate for losses arising in another for (a) an ongoing firm, or (b) a firm that is winding up? This factor determines the extent to which capital is “fungible” within the takaful organization and whether all participants have equal claim on the assets in the event of a winding up. For example, this affects whether a fund can default through weak performance on a single product or fund, despite strong performance on others. From a credit perspective, the more that surpluses and deficits are able to offset one another within the takaful sub-funds, the better.

• Whether the donation from participants is required to be binding or received prior to being considered as part of the participants' fund

  In principle, donations are offered on a courtesy basis and are not binding undertakings. This is an area that is frequently dealt with through legislation or regulatory requirements, which state that no risk can be accepted before a contribution is either received or guaranteed to be received.

• The definition of insolvency and the procedure for winding up the operation
• The ability of the regulator or other body to require a transformation of an interest-free loan from the takaful operator to a donation if it seems that the loan is unlikely to be paid

  The circumstances under which this transformation is required are important, as is the likely timing of such a requirement. The timing matters, as Fitch expects that regulatory powers requiring such a change may not be applicable after winding-up proceedings have begun.

12.5.4 Products

Within both general takaful (non-life or property and casualty insurance) and family takaful (life insurance), the product range that is offered can differ significantly from that offered by conventional insurers. This reflects a number of factors, including the geographical concentration of takaful firms in certain regions with particular market structures, but also the requirements of Shari'ah compliance. For example, takaful products tend to have a high degree of transparency associated with them due to the Islamic requirement for the contracts to be fair and to avoid unclear terms. Disclosure and the avoidance of ambiguity is, therefore, a critical aspect of product design.

Guarantees are very rarely offered with products as this can create an unbalanced contract, which is not permitted according to Islamic principles. Some product lines would not be Shari'ah compliant, such as whole-life cover or defined benefit pensions, as these offer forms of guarantee.

Some product types are only offered in a very limited way due to difficulties in controlling risk. For example, it can be difficult for takaful firms to offer annuity products on a large scale, due to the limited availability of appropriate sukuk to back them. The relative scarcity of high-quality instruments with a fixed return to match the annuity payments can make annuities difficult products to provide without taking excessive risk. In any case, Fitch understands that the Shari'ah prohibits the giving of a guarantee of the amount of an annuity, and hence, the taking of such a risk.

In practice, general insurance tends to be concentrated in motor and property insurance, with medical insurance, accident, and marine constituting the majority of the rest. A business line that has performed well may pay a distribution to participants where a surplus has arisen. The degree to which results are considered by product or in total can vary significantly between firms according to the applicable documentation.

The participants in takaful pools tend to be concentrated in the personal and small business sectors, with larger corporates using takaful solutions much more rarely. To the extent that personal and small business insurance lines are more predictable than those of larger corporates, a takaful portfolio may contain less risk than some conventional portfolios writing similar business lines.

12.5.5 Capitalization and Financial Flexibility

Fitch's approach to capitalization will vary to some degree according to the applicable legislation and the degree to which capital within the firm is available to participants. However, the agency believes that it is always important to understand the capital position of both the takaful fund and the operator (where these exist) so as to establish the source of financial strength for the firm. The following are areas that the agency expects to consider for each of these groups.

12.5.5.1 For Mutual Takaful Firms with No Segregation of Assets within the Undertaking

These non-commercial takaful firms are very similar to conventional mutual insurers in structure, although they aim to ensure that their investments and products, for example, are compliant with Shari'ah principles. In these cases, capital can be assessed in a very similar way to conventional mutual insurers using the agency's standard tools and methodologies.

12.5.5.2 For Takaful Firms where the Takaful Operator's Shareholders' Funds are Separate from the Takaful Policyholders' Fund (or Funds)

For firms that do have a separate takaful operator and takaful fund, Fitch would review capitalization from several perspectives:

An outline of possible methods for demonstrating the availability to participants of shareholder assets is described below. However, these possibilities are not necessarily exclusive, and Fitch is also prepared to consider other mechanisms for making shareholders' funds available to policyholders where these are applicable.

• Suitable local legislation is in place—that is, local legislation is such that in the case of a winding up of the takaful firm, participants have (preferential) legal recourse to the assets of the takaful operator. Under Shari'ah principles, assets of the takaful operator are only available to participants of the takaful funds in case of the operator's misconduct or negligence in performing its underwriting or investment management services. However, it is possible that local law might entail the takaful operator's assets being made available to creditors in a winding-up even though the operator is not contractually liable from a Shari'ah point of view. While such a situation may raise an issue of conflict between the civil law and the Shari'ah, it could potentially have positive implications for the credit assessment of the takaful undertaking.
• Suitable contractual and other documentation—in some jurisdictions, even if local legislation does not automatically grant policyholders recourse to the assets of the takaful operator, it may still be possible to obtain an equivalent effect through suitable wording of the takaful certificate (insurance policy), memorandum of association, and articles of association. Fitch, therefore, anticipates that with appropriate wording, firms may be able to demonstrate the availability to policyholders of a takaful operator's assets in such circumstances.
• The qard hasan is of a suitable form and suitable triggers are in place to require the loans to be made—in general, Fitch regards the qard hasan as a mechanism for providing limited relief for short-term difficulties in the takaful fund, rather than as a mechanism for providing recourse to shareholder assets. The directors of a takaful enterprise are required to act in the best interests of their shareholders and this is unlikely to extend to making interest-free loans to the takaful funds where these funds are in financial difficulties. However, if the qard hasan is compulsory, takes the form of a subordinated loan, and cannot be avoided by a winding-up of the enterprise, then this may lead to capital credit being available for the qard facility if the expected future loans would be of a suitable type.

A qard hasan will be regarded as being of a suitable type if the loans would be granted substantial equity credit according to Fitch's hybrid rating methodology. Further details on the necessary features for equity credit are given in the next section.

Fitch currently expects that it will be relatively rare for it to rate a takaful firm where the resources of the takaful operator are not available in some form to help avoid an inability of an underwriting fund to meet its obligations. If shareholder assets are not available to participants, Fitch would generally expect strong capitalization within the takaful fund itself or a highly demonstrable willingness on the part of the takaful operator to provide the necessary resources (for example, established through the use of the agency's group rating methodology). In such circumstances, Fitch would increase its focus on the capitalization of the takaful fund and make an assessment as to the potential support that the fund may receive from the takaful operator. Where the rating is entirely reliant on the takaful operator's willingness to provide support, Fitch may not be able to rate the policyholder obligations.

12.5.5.3 Other Capitalization Factors

Many takaful firms either choose or are required to build up capital within the participants' fund. This can be achieved either through allocating a certain percentage of the surpluses to build up as a reserve in the takaful fund or by building up contingency or equalization reserves. Such actions serve to reduce the dependency of the takaful fund on the resources of the operator and, in time, would be expected to improve the returns on capital to the shareholders of the operator. Although these reserves are frequently very low at the moment, given the relatively short track record of many takaful firms, Fitch expects them to become increasingly significant in the future and to become an important element of many takaful firms' business model.

Finally, it should be noted that takaful firms may have more limited access to funding, given the fact that they are not usually able to issue hybrid debt. In some cases, this may mean that takaful firms have lower financial flexibility (that is, less ability to source additional funds if required) than equivalent conventional insurers. Although financial flexibility is seen as a positive rating factor, given the size of most takaful firms, this difference in access to debt markets is currently more theoretical than actual in the majority of cases.

12.5.6 Interest-Free Loan (Qard Hasan)

Following on from the legal issues and the discussion of capitalization as outlined above, there is the question of how a rating agency would view an interest-free loan provided by the takaful operator to the takaful fund. Although it is an accepted practice for a takaful operator to provide an interest-free loan (qard hasan) facility which can be drawn down to enable a takaful fund to meet its obligations when it would otherwise be unable to do so, the rules surrounding this loan can differ meaningfully between cases.

When Fitch assesses credit for the qard hasan facility, the agency considers two main aspects from a ratings perspective.

12.5.6.1 Credit for Existing Interest-Free Loans

Existing interest-free loans will be treated in line with Fitch's current methodology referring to hybrid capital instruments such that capital securities are given equity credit if they fall into one of two tracks:

• Track A—this requires that the following features are met by the securities: (1) they are subordinated so that the instruments provide loss absorption; (2) they permit the deferral of interest payments; and (3) they have a suitable maturity of greater than five years; or
• Track B—the capital securities are mandatorily convertible to equity under certain defined conditions. Further details are available in the agency's published methodology on hybrid capital instruments.

In many cases (for example, in Bahrain and Pakistan), the qard hasan offered by the takaful operator is explicitly subordinated to the interests of policyholders. However, in other cases (for example, in Malaysia), this is not the case. There are no interest payments to defer, so this aspect helps to qualify the loan for a high degree of equity credit under Fitch's “weakest link” methodology. Finally, for the determination of equity credit, legislation may specify that the interest-free loan can only be repaid from future surplus, and therefore, the loan has no fixed maturity date. The absence of a fixed maturity date and suitable restrictions on the repayment of the loan, in conjunction with the other factors, would usually contribute to a very high level of equity credit being available for the loan. The terms of the qard hasan can make a significant difference to the credit offered and we would consider these on a case-by-case basis.

In the absence of legal specifications on the subordination of the qard hasan or on the terms of repayment of this loan, no equity credit (that is, treatment as capital) would typically be offered under Track A of the agency's existing rating methodology. However, where a mechanism is in place for the conversion of the qard hasan into a donation to the fund (Malaysia is again an example) then, depending on the terms of this conversion, Fitch will consider granting equity credit under Track B as described in the agency's published hybrid methodology.

12.5.6.2 Credit for Potential Future Interest-Free Loans

In order for credit to be given to future loans, Fitch must be convinced that the loan would be forthcoming and in a suitable form (that is, would receive high equity credit). Where a qard hasan is not compulsory, then the possibility remains that a takaful operator may choose not to make such a loan. For this reason, some countries specify that such a loan is required to make good any inability of a takaful fund to meet its obligations, either as part of the takaful legislation (for example, Pakistan), takaful regulations (for example, Bahrain), or as part of regulatory “guidelines” (for example, Malaysia). The agency understands that the provision of such a loan by operators in Malaysia may become compulsory in a legally enforceable sense under new legislation being considered by Bank Negara Malaysia.

However, for takaful firms relying on the qard hasan as back-up capital, Fitch would expect suitable triggers to be in place so that the provision of the loan cannot be avoided through a winding up of the firm, with the potential result that the takaful funds become insolvent and policyholders do not, in fact, benefit from the capital support of the takaful operator.

12.5.7 Investments

Fitch will not certify that investments are Shari'ah compliant. Nevertheless, the investment review is an important part of the overall analysis. The agency believes that takaful firms are potentially at a disadvantage relative to conventional insurers, given the investment restrictions to which they are subjected. (For example, interest-bearing instruments are not permitted, and restrictions exist regarding permissible investee industries.) Fitch will, therefore, assess the approach of management to this issue.

Investment restrictions associated with Shari'ah may have a credit impact, given the limited availability of sukuk investments and the consequent difficulty of investing in high-quality assets, while avoiding investment concentrations. These investment concentrations may relate to individual names or individual industries (for example, oil).

In addition, in some cases (although certainly not all), there appears to be a relatively high proportion of equity investments compared with conventional insurers, which increases the importance of assessing the risk associated with these instruments. Equity investments are generally associated with higher volatility than debt, and so it is a key area of focus to establish whether this results in higher risk compared with the situation for a conventional insurer. Fitch will also consider the extent to which investments are held with related parties. Such investments may be made on “soft” terms and can lead to a low quality of investment assets.

The liquidity of investments is also a key area to consider, given that many of the takaful firm's investments may not be listed. Although this is not an issue that is necessarily or exclusively associated with takaful firms, it is a feature of many developing markets and may be exacerbated by the limited availability of investment options for a takaful firm.

12.5.8 Reinsurance

Reinsurance (including the use of conventional reinsurance, retakaful or retrotakaful firms) is especially important for many takaful and retakaful operations. This is due to the small size of some operations, which in the absence of reinsurance support could lead to overexposure to a small number of events (that is, process risk). In addition, some firms rely on reinsurance for capital support given the difficulty in building up adequate capital buffers in some cases.

Especially given the importance of reinsurance in many cases, the agency seeks to gain information on the structure of the reinsurance program and the extent to which it can be relied on to offset risk. Although Fitch does take account of reduced underwriting risk stemming from reinsurance in its rating assessment, this benefit is partially offset by credit and dispute risk, which can be significant. This drawback particularly affects takaful firms that are using retakaful providers, as there may be pressure to compromise security in return for gaining compliance with Shari'ah principles. Equally, there may be a concentration of risk in the hands of a small number of retakaful firms, or in some cases, the retakaful firm used may have less pricing expertise than that of other conventional alternatives. Each of these would have credit implications that Fitch would take account of in its review.

12.5.9 Profitability

As with mutual insurance companies, assessments of profitability can be complicated for takaful firms, given that in some cases, they will not attempt to maximize their profits. Another challenge is to establish what a reasonable rate of return is, as this depends on the extent to which shareholders' capital is at risk. Fitch looks to establish the surplus that has been (and is likely to be) generated by the takaful fund, as well as the way that this surplus is liable to be distributed (or retained) by the fund over time. Fitch will also seek to determine whether profits under a mudarabah model are, in fact, distributed in accordance with the percentages stated ex ante, or whether the firm offers some other (maybe more stabilized) return to participants due to competitive pressures.

As well as any surplus arising within the fund, it is also necessary that the takaful operator is able to generate an adequate return on capital in order to be a viable long-term business and generate more funds if required. The profitability of the takaful operator can be assessed based on the shareholders' funds that are employed in the business and by comparison to both absolute levels of return and that of similar operations.

12.5.10 Risk Management

Risk management within a takaful undertaking has some important differences compared with conventional insurers. The lack of guarantees offered and the high degree of transparency usually associated with the products generally helps to reduce risk.

Risk management issues that would affect many companies in the main takaful regions would include the control of aggregation exposure to catastrophic risk (for example, earthquake, windstorm, and 'flu pandemic) and the concentration of risk in particular industries (for example, oil).

However, takaful firms are also much more limited in the forms of risk management that they are able to use. For example, a takaful firm would not usually be permitted to use investment derivatives (such as options, futures, and forwards) to control risks, as these instruments are usually deemed to contain unacceptable levels of uncertainty and have no underlying assets. Although Shari'ah-compliant versions of these instruments do exist in some cases, the liquidity associated with these markets is considerably reduced compared with the conventional alternatives.

The question of enterprise risk management (ERM—that is, the consideration of risk on a holistic basis rather than in individual silos) is particularly pertinent for the larger multinational insurers and reinsurers that have opened up takaful subsidiaries or windows. Such multinational insurers have been devoting significantly increased resources to ERM, and a common method of operation is the use of intra-group reinsurance arrangements in order to centralize risks. In the case of takaful operations that are part of conventional firms, such an arrangement may not be possible without violating Shari'ah principles, and so alternative methodologies for increasing the fungibility (that is, transferability) of capital within the group may need to be explored.

For smaller takaful players, the dominant issues around ERM may concern the quality of information that is provided to the board, as well as its timeliness. Where the accounting or risk team is inexperienced, part-time, or reliant on key individuals, risk factors may be somewhat elevated. All takaful firms need to ensure that they have suitable controls and training procedures so that the principles of Shari'ah are not inadvertently breached to protect the reputation of the firm.

12.5.11 Regulation and Accounting

12.5.11.1 Regulation

The regulatory and accounting framework used by takaful firms is generally at a much earlier stage of development than that used by equivalent conventional insurers. In some cases, the regulatory requirements (for example, those relating to investment holdings) require companies to breach Shari'ah principles by investment in non-compliant instruments. That said, there has been significant development in some regulatory regimes over recent years, with an increasing number of countries developing regulations that are specifically targeted at the takaful sector.

A key challenge for regulators will be ensuring adequate protection for takaful participants, especially while many takaful firms have modest capital within the takaful fund (or funds). Where applicable, this modest capitalization within the fund generally reflects the structure of many takaful operations with capital provided not by shareholders but by participants in the takaful scheme. As a result of this structure, surplus within the takaful fund takes some time to accumulate and, partially reflecting this, some regulatory regimes require relatively low levels of capitalization for takaful businesses. As discussed earlier, the capital available to participants can be enhanced through appropriate legal provisions which require that takaful participants have access to back-up capital from the takaful operator—for example, in the form of a (subordinated) qard facility. Alternatively, the takaful operator may make a donation to the takaful fund (for example, with the fund set up using the Islamic concept of waqf) to ensure that the latter's capitalization is adequate.

While protection for participants may be enhanced by requiring relatively high levels of solvency for takaful firms in the early years of the operation, this may also slow the development of the industry. A failure to apply equivalent capital requirements to takaful and conventional insurers could potentially lead to inadequate protection against insolvency for takaful policyholders, as well as encouraging regulatory arbitrage.

Regulators face the challenge of developing rules and regulations for an industry that has developed with relatively little consistency between firms. This makes regulation more complex as benchmarking is more difficult and it can take longer to understand each undertaking. Different regulators currently have quite different approaches to the regulation of takaful firms.

In addition to the issues above, regulators also face many of the same issues as the takaful firms, such as trying to recruit and retain skilled experts in the area of takaful.

12.5.11.2 Accounting

Accounting regulations continue to require development to cope with the unique features of takaful firms. For some firms, guidance is currently provided by a number of sources—for example, including International Financial Reporting Standards, the Malaysia Accounting Standards Board (MASB), the Accounting and Auditing Organization for Islamic Financial Institutions, or by regulators (for example, Bank Negara Malaysia). (See also Chapter 13.)

The result of having multiple applicable accounting standards is often a lack of clarity. The absence of specific and widely accepted accounting principles also results in a lack of consistency in the way in which companies prepare their accounts. Accounting difficulties are heightened in the case of takaful operators, as these organizations have control over the assets of a takaful fund but limited rights to the risks and rewards of ownership. Such challenges mean that accounts prepared by a takaful firm could potentially be misleading in the absence of skilled interpretation.

Fitch considers that further development (and harmonization) of accounting standards for takaful firms would be beneficial for the industry. For example, Fitch would welcome accounts that showed more detail on the results and financial position of the takaful fund as distinct from the takaful operator. Additional accounting disclosure that Fitch would like to see includes:

• disclosure of the cumulative surplus or deficit by line of business, as this is not always provided. In addition, it would be helpful to make clear the extent to which surpluses and deficits on each line are able to offset each other;
• clear disclosure of contingency reserves, equalization reserves, and surpluses which exist in the takaful funds;
• information on the business model used and the basis of remuneration of the takaful operator (for example, wakalah, mudarabah, and relevant percentages); and
• a breakdown of the transfer to the revenue accounts of the takaful operator. There is often very limited information on how the amount transferred has been calculated.

12.5.12 Ability to Address the Main Challenges Facing Takaful Firms

The ability to address the main challenges that are faced by takaful firms is an important rating issue for individual takaful firms as well as for the industry itself. These challenges include factors such as:

• strong competition both from conventional insurers, which may be able to earn a greater investment return and have greater economies of scale, as well as from other takaful businesses. Economies of scale are a particular challenge due to the small size of many takaful operations;
• the lack of a clear regulatory and accounting framework for takaful providers in some cases;
• a shortage of skilled staff;
• modest levels of capitalization among many takaful businesses, especially within the takaful fund. Increasing this capital base within the takaful fund is a particular challenge, as the surplus is provided by the fund's participants and would usually only grow gradually over time;
• a need for training and compliance to ensure that Shari'ah practices are understood and adhered to by the workforce;
• a scarcity of suitable (Islamic-compliant) investments and reinsurers. These shortages can lead to concentration risks or lower-quality assets than desired by the takaful businesses;
• competition between the mudarabah and wakalah business models, which contributes to confusion among consumers and may serve to slow down the development of the takaful market. This is especially true as takaful operations using competing models in some cases criticize the alternative business model, only serving to restrict the potential of the market;
• the limited availability of risk management instruments such as derivatives or long-term instruments offering a fixed return to assist in asset and liability management, which makes risk management more challenging; and
• the need for careful product design to ensure both a suitable risk profile and compliance with Shari'ah principles. An adequate infrastructure, including an effective IT platform and control processes, is also necessary.

The more individual firms and the industry as a whole can address these issues, the higher ratings are liable to be.

12.5.13 Shari'ah Compliance

A key point to note is that Fitch will not “approve,” certify, or evaluate Shari'ah compliance. The agency is well versed in credit issues but is not well placed to determine what is or is not in compliance with Islamic principles, which is a complex and subjective area. The agency will rely on the firm's Shari'ah board and, where applicable, national (that is, regulatory) Shari'ah councils in this regard.

12.5.14 Rating Methodology Issues

There are several important methodology issues that need to be established as part of rating a takaful firm, especially where the firm is set up as a commercial organization. For example, an important element in establishing a rating approach for takaful/retakaful firms with a separate takaful operator and fund is to determine whether these elements should be reviewed separately or as a combined group.

Particularly for commercial operations, Fitch considers that it is very important to understand the sources of the takaful firm's financial strength (that is, the takaful fund, the operator's shareholders' funds, or both). By looking at each of these elements individually, Fitch can better understand the components of the firm's financial strength and identify potential weaknesses. The procedure also recognizes that the takaful operator's shareholders' and policyholders' funds are managed separately and capital may well not be fully fungible (that is, transferable) between the two. For example, in some cases, a takaful operator with a high expense ratio and weak capital could theoretically fail, even if the takaful fund is performing well and has a significant surplus. It is, therefore, not sufficient to review the takaful firm solely on an aggregate basis.

Other issues that Fitch has addressed in its methodology include the definition of default, as well as whether ratings apply to the takaful firm or to a single takaful fund.

12.5.15 Other Issues

Many takaful firms have a limited operating history, especially given the large number of relatively recent start-up companies. Fitch can and does assign ratings to start-up operations based on a close inspection of the business plan, management team, and business environment. However, the agency believes that such operations are usually subject to greater risks than those that have been operating for some time and are, therefore, more established in their market with a seasoned portfolio. As a result, firms that have a short operating history would usually have a higher credit risk compared with a more mature operation. Such elements can be offset, to a greater or lesser extent, by an experienced management team, other business strengths, and by group support.

Other issues that relate to takaful firms as much as to other insurers include the adequacy of current technical provisions and reserves, quality of underwriting, and effectiveness of distribution channels, among other factors. For example, the agency would expect to establish the adequacy of current technical provisions after making enquiries about the provisioning process, the techniques applied, and the historical reserving experience, as well as reviewing any available evidence such as external provision studies. The review would include establishing whether there is a particular confidence level targeted for provisions, whether claims provisions are set on an undiscounted or discounted basis, and the extent to which contingency or equalization reserves exist. The latter forms of reserves will be treated as part of available capital, in line with the agency's usual treatment of such reported reserves.

12.6 CONCLUSION

It is clear that there are a number of significant issues for a rating agency to consider as part of the process of assigning ratings to a takaful firm. For example, the business model and set-up employed can vary substantially between firms, and so understanding the set-up, aims, and objectives of the organization is a critical first step in the rating process.

In addition, the legal and regulatory position can vary significantly between countries, resulting in policyholders potentially having different degrees of protection against the insolvency of underwriting funds in the event of financial difficulties. Such differences can have an important impact on both the probability of default for a takaful or retakaful firm as well as the recovery given default, both important elements in determining an appropriate rating.

For all takaful firms, Fitch will take into account investment concentrations where these exist, potential corporate governance issues, and, in some cases, relatively short operating histories. Against these issues, the agency will balance the firm's risk appetite and the impact of product design, as well as other risk mitigation techniques that have been employed by management.

The agency expects that for many commercial takaful firms at the present time, the availability of resources from the takaful operator to help avoid the inability of an underwriting fund to meet its obligations will play a substantial role in establishing suitable protection for policyholders. Fitch, therefore, considers that it will generally be important for a rated firm to be able to demonstrate the availability to participants of such resources in the event of financial stress.

Possible methods of demonstrating the availability of shareholder assets to participants include, but are not limited to:

• suitable legislation being in place such that participants have (preferential) recourse to the assets of the takaful operator in the case of a winding up of the takaful firm;
• suitable wording of contracts, as well as memorandum and articles of association, to have the same effect as the method above; or
• credit for some part of shareholders' assets may be available to the extent that these assets have already been loaned to the takaful fund. In order to receive credit, this loan would either have to be subordinated to the interests of policyholders and have suitable restrictions on repayment, or else have a suitable mechanism for conversion into a donation.

In order for full credit to be given to future loans, rules would usually have to be in place to ensure that the qard loans cannot be avoided through a voluntary winding up in a stressed scenario. In the case of a requirement to provide a qard hasan, the agency would need to be confident that the requirement would be legally effective.

The issues that are discussed here are largely additional to those that are faced by conventional insurance companies, as detailed in Fitch's criteria reports for analyzing conventional insurance companies and in various special reports. The agency considers that it is important for takaful firms and other stakeholders in the industry to consider all of these issues in assessing the financial security of takaful obligations.

 

 

Notes

1 The author acknowledges the kind assistance of Andri Aidham of Kadir, Andri and Partners in research which contributed to the preparation of this chapter. Fitch is responsible for the chapter's contents.

2 See the discussion of these issues in Chapter 4 of this book.

3 Editors' note: As the qard is a benevolent loan according to the Shari'ah, it cannot be a contractual obligation of the takaful operator. Any such obligation, therefore, needs to be imposed by regulation backed up by the secular commercial law.

4 Editors' note: The Shari'ah does not accept the subordination of some creditors' rights, but this might be imposed by legally backed regulation.