Concluding Remarks
Takaful is the means of bringing the social and economic benefits of modern insurance coverage, in a form consistent with their religious beliefs, to Muslims and to the emerging economies of many predominantly Muslim countries. As such, the development of takaful is crucial, both to social inclusion in non-Muslim countries and to economic development in a number of countries with emerging market economies.
Yet the development of takaful faces some formidable barriers, which have been examined in this book. These barriers are largely due to the complex structure of takaful undertakings and the unresolved issues associated with it, which make the development of an appropriate legal and regulatory infrastructure for takaful problematic. Other problems are the consequence of the newness and relatively small size of many takaful undertakings, coupled with a lack of Shari'ah-compliant reinsurance (retakaful) capacity, within a globalizing insurance industry in which the “law of large numbers” and risk diversification play a key role and economies of scale are of major importance.
This chapter sums up the conclusions on these matters that may be drawn from the chapters that precede it. Section 14.2 focuses on the unresolved issues resulting from the complex structure of takaful undertakings. The resultant regulatory and legal problems, including those in relation to corporate governance and policyholders' rights, to capital adequacy and solvency, and to external rating of takaful undertakings, are reviewed in Section 14.3. These problems call for a comprehensive legal and regulatory framework, the need for and scope of which are reviewed in Section 14.4. Section 14.5 summarizes the work of the Islamic Financial Services Board in developing international prudential guidelines in the context of these problems. Section 14.6 sets out some thoughts for the future.
14.2 THE STRUCTURE OF TAKAFUL UNDERTAKINGS AND RESULTANT UNRESOLVED ISSUES
The origins of takaful, as its name suggests, lie in forms of mutual protection against losses (solidarity) that existed traditionally in Muslim societies. Yet in many, if not most, of the countries in which takaful is now developing, not merely are mutual forms of legal entity not recognized by company law, but the very concept of such entities is unfamiliar. Instead, regulators and legislators are aware of the structures of proprietary insurance companies. Consequently, a hybrid form of insurance undertaking has been developed for takaful, in which the policyholders' funds operate on a mutual basis but are managed by a takaful operator, which is a company with shareholders. This hybrid structure raises a number of issues that have yet to be resolved, with negative consequences for the quality of the legal and regulatory infrastructure for takaful. From a corporate governance perspective, the respective rights and obligations of the policyholders and the shareholders need to be clarified.
The situation is further complicated by the fact that the participants' (policyholders') risk funds typically have not built up the reserves needed to meet regulatory requirements for capital adequacy and solvency, so that the issue arises of whether, or of the extent to which, the capital of the TO stands behind the participants' risk funds for regulatory purposes, given that the TO is prohibited by the Shari'ah from taking on underwriting risk in return for a reward. In this context, the treatment of the assets of policyholders' funds and of shareholders' funds, respectively, in the event of the winding up of an insolvent risk fund, or of an insolvent TO, is a key issue with which the legal system needs to be able to deal equitably and in compliance with the Shari'ah.
14.3 CORPORATE GOVERNANCE AND RELATED MATTERS
14.3.1 Corporate Governance
In contrast to policyholders in a conventional mutual insurance company, who are the owners of the company, participate in general meetings, and have the right to remove the management, takaful participants have no such governance structures or rights, although in principle, they are exposed to similar insurance risks. In fact, takaful participants seem to have no more governance rights than the policyholders of a conventional proprietary insurer, and (in the absence of supervisory action backed up by appropriate regulation) must rely on market competition to get a fair deal and good value for money in their dealings with the TO. Yet, typically, there are not many competitors in each national market for takaful, so market competition may not provide much protection.
The use of the classical fiqh contracts, notably mudarabah and wakalah, in takaful structures, has had the effect that such structures give virtually unfettered power to the operator, subject to the governance rights of shareholders, and make no provision for any governance rights of participants. The only restraint on the powers of the operator in its dealings with participants lies in its fiduciary duty to them. In the circumstances, one must expect the operator to give the interests of its shareholders priority over those of participants. The implications of this for insurance supervisors are discussed below.
14.3.2 Risk Management and Investment
Regulatory regimes for insurance typically include restrictions on the right to invest in the riskier asset classes. A more recent approach, followed in Solvency II, is to replace such restrictions by asset risk weightings, which implies an explicitly risk-based approach to supervision. However, as pointed out in Chapter 11 of this book, the emerging market countries where most takaful undertakings are based mostly do not have regulatory regimes for insurance that take appropriate account of investment risk, let alone regimes that allow for the particular risk characteristics of takaful undertakings as described in Chapter 9 of this book.
14.3.3 Capital Adequacy and Solvency, and Related Shari'ah and Legal Issues
As noted above, the participants' risk funds in a takaful undertaking will typically not contain sufficient reserves (participants' equity) to meet regulatory solvency requirements. There seems to be a widespread assumption that the capital of the TO is available to stand behind the risk funds. Indeed, in a jurisdiction where mutual forms of company were accepted, the TO as a company with shareholders would arguably have no raison d'être other than the provision of capital backing to the risk funds.
From a Shari'ah perspective, however, the TO is not permitted to take on underwriting risk in return for a reward. On the other hand, to do so for no reward would hardly be fair to the shareholders whose capital would be put at risk. An ingenious way around this dilemma has been found in the form of a qard facility offered by the TO to the takaful risk funds. As any such loan is repayable out of future underwriting surpluses, it does not per se constitute exposure to underwriting risk. The operator is not entitled to any return on the loan, but receives a fee for managing the underwriting of the risk funds.
Various issues arise in connection with this qard facility.
- Since the operator presumably has to hold capital to cover the amount of the qard facility offered, does the TO's right to earn a fee for managing the underwriting of the risk funds represent an appropriate reward for the shareholders?
- As a qard is a benevolent loan in Shari'ah terms, making it available cannot be an obligation of the TO within the contractual structure of the takaful undertaking. Any such obligation needs to be a regulatory requirement backed up by law (in case the shareholders seek to oppose its being made by legal action).
- How is the facility to be treated in evaluating the capital adequacy of the takaful undertaking? From a Shari'ah perspective, the loan cannot be considered as being formally subordinated to the rights of other creditors, as the Shari'ah requires all creditors to be treated equally, and does not permit subordination. However, the intention in making the loan is clearly to enable the risk fund to meet its obligations to claimants, and hence, to avoid insolvency; hence, would the obligations to claimants in this case be met prior to any repayment of the loan? But if the fund subsequently has to be wound up or go into run-off, what then is the status of the loan? The answers to these questions may affect the treatment of the qard facility in meeting regulatory solvency requirements.
Other questions arise with regard to the winding up of an insolvent takaful operator. To what extent, if at all, are the assets of the participants' risk funds available to meet claims of creditors of the operator? It might seem obvious that these assets would be “ring fenced” against such claims, as according to the Shari'ah, they belong to the participants, not the shareholders. However, given that the secular law might not recognize these funds as separate entities from the TO, it may not make the distinction that is clear in the Shari'ah, and thus, there might be no “ring fencing.”
Such considerations regarding the capital of the undertaking, and how its solvency may be evaluated, are also highly relevant for the purposes of external credit ratings. Such ratings may significantly affect the competitive position of a takaful undertaking. But the answers depend on the legal and regulatory position in each jurisdiction, and, as mentioned above, on the complexities of takaful undertakings, and the resultant needs in terms of the legal and regulatory infrastructure applicable to them are not yet well understood in a number of jurisdictions.
A further point concerns the treatment of underwriting surpluses, particularly in general (non-life) takaful. In the structures of some takaful undertakings, the TO is entitled to a substantial share of underwriting surpluses, as though they were part of profits (which, in a mutual structure, they are not). In addition, it is quite common for distributions to be made to policyholders out of underwriting surpluses. Given that a major issue with regard to the solvency of takaful undertakings is the lack of participants' equity and the consequent dependence on a qard facility from the TO (which raises various problems mentioned above), it would seem desirable for underwriting surpluses to be retained in the risk funds so as to build up participants' equity, and for the regulatory framework to encourage, if not to require, this. Conventional mutual insurers have typically followed such a policy, which enabled them to build up the reserves permitting them to survive without any other capital backing.
14.3.4 Business Conduct Issues
The insurance industry generally, and life insurance in particular, does not enjoy the best of reputations for the quality of its conduct of business, the most notorious failings being in the area of product mis-selling. Takaful is not exempt from the dangers of such failings, particularly in view of the complex and somewhat ambiguous structure of takaful undertakings, and the resultant questions regarding policyholders' rights. Moreover, as indicated in Chapter 11, takaful undertakings are exposed to a particular type of insider dealing, when the TO invests policyholders' funds in the equity of companies that are significant shareholders of the TO company.
In Chapter 6 of this book, among a number of points mentioned as key drivers for developing the market infrastructure for takaful while promoting good business conduct, emphasis was placed on the need for regulators of takaful to require greater transparency and public disclosure, and to promote and be able to place reliance on market discipline. Nevertheless, in an emerging market environment, it is not evident how much faith may be placed either in market discipline or in competition as a substitute for regulation and effective supervision.
14.4 THE NEED FOR, AND SCOPE OF, A COMPREHENSIVE REGULATORY FRAMEWORK FOR TAKAFUL
Earlier chapters of this book have drawn attention to aspects of takaful which are inadequately addressed by existing legal and regulatory frameworks that are not designed to cope with the specificities of takaful. These were summarized above in Section 14.3. An appropriate framework needs to address the issues of:
- corporate governance and policyholders' rights;
- risk management and investment;
- capital adequacy and solvency; and
- business conduct.
It was noted in Chapter 2 of this book that, while the character of takaful undertakings as hybrids gives rise to issues for regulators that are additional to, and in some ways more complex than, those raised by conventional insurance, procedural and structural rules and regulations specific to takaful are still rare exceptions. Moreover, there are examples of national regulations for takaful that fail to take account of the mutual character of underwriting in takaful and the inappropriateness of treating a takaful underwriting surplus as a profit of which the TO may receive a substantial share.
Developing an appropriate regulatory and supervisory infrastructure for takaful represents a formidable challenge for the authorities in an emerging market environment. The IFSB has endeavored to facilitate meeting this challenge by developing a series of guidelines which are briefly described below.
14.5 THE WORK OF THE IFSB IN DEVELOPING INTERNATIONAL PRUDENTIAL GUIDELINES FOR TAKAFUL UNDERTAKINGS
The IFSB is producing three exposure drafts that are applicable to takaful undertakings, two of which, on governance and solvency, are specifically intended for takaful, while the third, on conduct of business, will be applicable to all Islamic financial institutions.
A major concern of the IFSB in drafting the Guiding Principles on Governance of Islamic Insurance (Takaful) Operations was the protection of policyholders (participants), in light of their lack of governance rights in a structure that includes shareholders with the governance rights to which shareholders are normally entitled. Such a situation may well result in shareholders' interests being systematically given preference over those of policyholders. The idea of giving policyholders the right to participate in governance, by having the right to elect representatives to the board of directors and to attend and vote at general meetings, was not, however, pursued, even for family takaful. Under a mudarabah contract, the policyholders would be in the position of rabb al maal, and as such, would have no right to interfere in management. Whether this prohibition extends to a role of oversight (which is not the same as interference) is not clear. The prohibition would also apply in the case of a wakalah contract.
In any event, research has indicated that policyholders in conventional mutual insurance companies tend to behave passively, rather than availing themselves actively of a right to elect directors and to vote at general meetings. This implies that such a right would probably not afford takaful policyholders effective protection of their interests. Instead, the draft Guiding Principles propose that the governance structure should include a governance committee, being a committee of the board of directors but with only non-executive members. It is suggested that these include at least the following:
- an independent non-executive director (selected for the director's experience and ability to contribute to the process);
- a Shari'ah scholar (possibly from the TO's Shari'ah Supervisory Board); and
- an independent actuary.
One of the main roles of the governance committee would be to ensure fair treatment of participants. The IFSB exposure draft Guiding Principles on Conduct of Business for Institutions offering Islamic Financial Services was also written with the protection of actual and potential takaful participants' interests very much in mind. Apart from the issues arising from the complex structure of takaful undertakings that were discussed above, and their implications for the protection of policyholders' interests, the life insurance industry more generally has had a poor record in recent decades in its treatment of customers, notably through the mis-selling of products that lack transparency and the failure to meet policyholders' reasonable expectations.
The exposure draft of the IFSB guidelines on capital adequacy and solvency of takaful undertakings was still in the process of being written when this book went to press. However, the most knotty issues with which these guidelines need to deal with have been discussed above. From a legal and regulatory point of view, the rules for the evaluation of solvency are set out as part of the regulatory framework of each jurisdiction. For the IFSB guidelines to be effectively implemented, some changes in these rules, to take account of the specific structural characteristics of takaful undertakings, are likely to be necessary in a number of countries.
14.6 SOME THOUGHTS FOR THE FUTURE
This book aims to create more awareness of the issues outlined above, with the hope particularly of stimulating improvements to the regulatory and supervisory infrastructure for takaful. It is true that Shari'ah prohibitions on the trading of debt and on conventional forms of credit insurance have provided protection from the gross deficiencies in credit risk management that resulted in the sub-prime mortgage securitization débâcle and the need for one of the world's largest insurance companies to be rescued. Yet it should be borne in mind that mortgages based on ijarah are securitized and the resultant sukuk are tradable. Some of these (ijarah asset-backed sukuk) are without recourse to the originator or the issuer. Moreover, types of Shari'ah-compliant credit insurance (based on takaful) exist and may well develop so as to offer improved facilities for credit risk management in Islamic finance.
Hence, a scenario is conceivable in which (a) unscrupulous agents or brokers arrange such ijarah-based financing without normal credit criteria being applied to the ijarah lessees, (b) Islamic banks agree to such financing which they securitize without recourse in such a way as to avoid any credit risk, (c) the resultant sukuk are traded and widely purchased by Islamic banks among others, and (d) the real estate market enters a downturn in which the value of the underlying ijarah assets is impaired. With respect to the subject of this book, favorable credit ratings helped by Shari'ah-compliant credit insurance offered by takaful undertakings might form part of such a scenario, and such undertakings would then be likely to find themselves in difficulty. Obviously, any such phenomenon would be on a far smaller scale than the conventional sub-prime mortgage securitization crisis, but that should not be a reason for complacency in regulation or supervision.
While over-regulation and heavy-handed supervision in a jurisdiction discourage financial services firms from operating in that jurisdiction through adverse regulatory arbitrage, weak regulation and lax supervision do not provide beneficial regulatory arbitrage as they are inimical to the reputation of a jurisdiction and unattractive to high-quality financial services firms which seek a well-regulated environment. Hence, those jurisdictions that take the lead in developing an appropriate regulatory and supervisory framework for takaful can expect to reap the benefits by attracting high-quality takaful and retakaful undertakings, including Shari'ah-compliant subsidiaries of major international insurers and reinsurers. One may mention in this context countries such as Bahrain, Dubai, and Malaysia, which have made important first steps in this direction, and are thus well placed to achieve further improvements such as those suggested or implied by this and the foregoing chapters.
Advances in regulation and supervision are typically made thanks to inputs from industry leaders. In the case of takaful, one problem is that many such leaders come from a background of conventional proprietary insurance, and are unfamiliar with the principles of mutual insurance and their implications for takaful. Consequently, the advice that they give to the authorities with regard to the design of regulation for takaful may be unsound in some important respects. We hope, therefore, that those insurance industry leaders who apply their expertise to developing the takaful sector will be among the readers of this book.