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An overview of takaful in


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An overview of takaful in

  1. 1. PhD and MIF Programs Project Paper An Overview of Takaful in Malaysia Corporate Finance FN 5033/6033 Professor Dr. Shamser Mohamad September 2012- Semester Name Student ID ProgrammeMace Abdullah 1000491 PhDYerkebulan Amanbayev 1100079 MIFGamal Salih Omer 1200073 PhDAhamed Elobied 1200074 PhD Page 1
  2. 2. AbstractTakaful is the Islamic alternative to insurance; it is not insurance per se. The Arabic word forinsurance is tamein, which means to reassure or guarantee through indemnification of losses.Conventional insurance uses voidable (fasid) contracts called policies through whichindividuals or firms receive indemnification against losses. Conventional insurancecompanies pool policyholder risks in a form of risk intermediation. Each policy is privatelyowned. Takaful, by contrast, not only pools risks, but also pools funds through the use ofcontracts that are Shari’ah-compliant. Takaful is not what it purports without compliancewith its religious norms and prohibitions. Although Takaful must still be regarded as nascent,it has shown remarkable growth in Malaysia. As Takaful grows it will inevitably intersectwith insurance, aspiring to replace insurance as the preferred mode of risk intermediation.However, Takaful will need to answer many questions along that arduous trek. Can Takafulcompete with conventional insurance in the areas of risk management, financial performanceand innovation? Will Takaful adhere to its epistemology along the way, or will it mimicconventional insurance? Malaysia is a world leader in Takaful. The answers to thesequestions may well be answered in Malaysia. This paper analyzes recent financial data,Malaysia’s regulatory and oversight regime, Takaful’s risk profile and other factors to draw an analytic picture of Malaysia’s Takaful industry.Key terms of the researchTakaful, Insurance, Takaful risks, Insurance risks, Malaysian Takaful, Takaful financialintermediationObjectives of the research: The objectives of this analytic research are to:  Assess the development of Takaful in Malaysia  Compare Takaful with conventional insurance in Malaysia  Compare Takaful in Malaysia with Takaful worldwide  Identify Takaful’s risk profile  Evaluate Takaful’s financial role in Malaysia  Examine Takaful’s financial performance  Discuss Takaful’s growth prospects  Assess the future of Takaful in Malaysia 2
  3. 3. Table of ContentsI. Introduction A. Epistemology B. Historical BackgroundII. Shari’ah Norms and Prohibitions A. Distinctions from Conventional Insurance B. Shared Attributes with Conventional InsuranceIII. Takaful in Malaysia A. Evolution & Development B. Current Status C. Organizational Models D. Malaysian Classifications E. Taxation in MalaysiaIV. Regulatory Oversight & Standard Setting A. Legislative History B. Bank Negara Malaysia C. Islamic Financial Services Board (IFSB) D. Accounting Association of Islamic Financial Institutions (AAOIFI) E. Role of Shari’ah Boards & Committees F. FatawahV. Risk Attributes of Takaful A. Risk Profile B. Risk Intermediation C. Retakaful D. TIPSVI. Financial Attributes of Takaful A. Financial Intermediation B. Capital Structure C. Growth PatternsVII. Conclusion & FindingsReferences 3
  4. 4. I. INTRODUCTION A. Epistemology1 Islamic financial institutions have a collective religious obligation (fard kifayah)imposed upon them by the Shari’ah. This obligation includes the necessity for Shari’ah-compliant financial intermediation in a Shari’ah-compliant manner. It mandates the need topreserve wealth and mitigate harm (Farook 2007). Takaful, as a key Islamic financialinstitution, has religious obligations concomitant with its roles in the Islamic financialsystem. Technically, its primary roles are risk mitigation and financial intermediation.Religiously, its primary roles are social wellbeing and mutual assistance. These roles must bereconciled periodically to insure that Takaful retains its pristine purpose. Takaful is firmly grounded in religious commands (talab) and obligations (ijab). YetTakaful is not explicitly prescribed in Shair’ah, i.e. by name. Rather, mutual support andassistance are commanded and are fundamental to Islamic social wellbeing and the Islamicfinancial system. Almighty Allah advises those who believe (mu’mineen): "O you who believe…assist (ta’awanu) one another in birr (the doing of good) and taqwa’a (having consciousness of Allah). Assist not one another in sin and transgression, but keep your duty to Allah" (Qur’an 5:2)2. Islam requires brotherhood and solidarity among believers and steadfastness againstthose who seek to cause harm; economically or otherwise. Almighty Allah advises thebelievers: “And hold fast (cling) to the rope (habl) of Allah all together (jami’aa) and do not be divided…” (Qur’an 3:103).The Arabic word “habl” has etymological meaning of a promise of assurance, security, orsafety and a thing well known to which one clings, causing unity (Lane 1863). In short, itimplies solidarity. The importance of solidarity among the believers has been emphasized by theProphet, AS3. Abu Musa, RAA4, reported Allahs Messenger, AS, as saying: “A believer is like a brick for another believer; the one supporting the other” (Sahih Muslim, Bk. 32, #6257).And he emphasized the common interests and shared concerns of believers, when he said: “You will see the believers in regard to their mutual love, affection and compassion, like the example of a single body; when any limb aches, the whole body aches” (Sahih Bukhari #6011 and Muslim #2586 with similar phrasing in Musnad Ahmad). These textual proofs of the call to solidarity and mutual assistance to stave-off harmare buttressed by numerous legal maxims (quwaid al-fiqhiyyah) that support the common 1 Simply put, epistemology is the study of knowledge and seeks to distinguish between what we believe to be true knowledge from that which we believe to be false knowledge. 2 References to Qur’an in this paper, refer to a translation by Muhammad Mohar Ali (former professor of History atMadinah University and graduate of Imam Muhammad University, Riyadh, KSA), “A Word for Word Meaning of the Qur’an” (Jami’yat ‘Ihya’a Minhaaj as-Sunnah (Ipswich, Suffolk 2003). 3 AS is used throughout this paper stands for the prescribed salutation upon the Prophet of Peace be upon him. 4 Throughout this paper, the term RAA is in reference to the honor Muslims are instructed to give to the companions of the Prophet, AS, i.e. “Radhi Allaahu anhu” or may “Allaah be pleased with him.” 4
  5. 5. responsibility of mitigating harm. For example: “Hardship is to be alleviated” (al-mashaqqatajlub al-tasysir) and “Prevention of harm takes priority over securing of benefits” (dar al-mafasid awla min jalb al-manafi). (Kamali 2006). Accordingly, Muslim scholars have concluded that among the ultimate objectives ofthe Shari’ah is that of serving the interests of all human beings (jalb al-masaalih) and to savethem from harm (daf’a al-mafasid). (Bouheraoua 2011). Preservation and protection of theessentials of human beings is established under the Objectives of Islamic Law (Maqasid ash-Shari’ah) as necessities of life (dururiyyat). These essential rights that are to be preservedinclude the protection of: faith (din), life (nafs), family (nasl), intellect (‘aql) and property(ma’al). Ibid. Thus, Islam calls mankind to engage in mutual cooperation or assistance (ta’awun) inpreserving and protecting from harm those things deemed good, including property, familyand life itself. It is well established Fiqh, that “(d)ifficulty begets facility; that is to say,difficulty is the cause of facility and in time of hardship consideration must be shown”(Mejella, Article 17). And the command that “Harm must be eliminated” (adh dhararyuzaal), which is another legal maxim derived from the Hadith narrated by Ibn Abbas, RAA,that the Prophet, AS, said: “Neither harm nor be harmed” (laa dharar wa laa dharaar). (IbnMajah). B. Historical Background That Takaful has religious roots is undeniable. Yet, as is the case with other forms ofhuman dealings (mu’amulat), it also finds its genesis in early forms of mutual cooperation.The Prophet, AS, saw some of these practices among the Arabs, e.g.:  Merchants of Makkah formed funds to assist victims of natural disasters or hazards of trade journeys (museebah). This was a form of surety called damman khatr al-tariq and was based on perceived risks of loss due to hazards on trade routes.  Contracts, called aqd muwalat, were entered into for bringing about an end to mutual enmity or revenge.  Alliances were formed by means of hilf or confederacy agreements.  Assistance relating to the payment of “blood-money” or diyah was provided to captives and the families of murder victims (qisas) through a tribal form of assistance known as ‘aqilah. (Obaidillah 2005). It is ‘aqilah from which Takaful can trace its Fiqh origins back to the time of theProphet, AS, wherein he rendered judgment on the doctrine of ‘aqilah. The Prophet, AS,being aware of this tribal practice, is reported to have used ‘aqilah in his rulings as follows: “Narrated by Abu Hurairah (RAA), he said that once two women from Huzail clashed when one of them hit the other with a stone which killed her and the baby in the victim’s womb. The heirs of the victim brought an action to the court of the Prophet (AS) who gave a verdict that the compensation for the foetus to be a male slave or female slave while the compensation for the killed woman is a blood money (diyat) to be paid by the ‘aqilah (the relatives of the father’s side) of the killer.” Bukhari, Vol. 9, # 45. And as noted by Obaidillah, the Sahifatul Madinah or Constitution of Madinah,enacted by the Prophet, AS, assured certain forms of ta’awun or mutual cooperation would be 5
  6. 6. implemented and upheld. Obaidillah explains that it contained three (3) aspects of ta’awun,including:  “Provision for social insurance affecting the Jews, Ansar and the Christians.  Statement that "the immigrants among the Quraish shall be responsible for their word and shall pay their blood money in mutual collaboration."  Provision for ransom (fidya) whereby payment is made to rescue the life of a prisoner and the relatives (‘aqilah) could cooperate to free him.” Thus, the Prophet, AS, took a tribal custom and transformed it into a rule of law(hukm ash-Shari’ah) for mitigating harm by and among the people. It can be seen from theabove that Takaful has its origin in customs or ‘urf or abah of the Middle East. It can be saidthat it is part of the Sunnah of the Prophet, AS, that he acquiesced in matters of ‘urf or adahthat contained good in them (a form a Sunnah called Sunnatul taqririyyah or tacit approval).(Kamali 1991). ‘Urf is an Arabic word that connotes “knowing.” It is established practices amongpeople (well known) that are deemed to be beneficial and for their wellbeing. One of itscharacteristics is that it is communal and practiced throughout the society repeatedly andcontinuously (OIC 1988). Thus, its prevalence is al-amm or general. It must have attributes ofbeing sound and reasonable. It may be verbal, but in this instance, the form being identified isthat of a practice (‘urf fi’li). (Nyazee 2004). ‘Urf cannot contravene the Shari’ah. As is the case, in general, with other forms ofmu’amulat, its starting point, absent a textual prohibition found in Qur’an and Sunnah, is thatof permissibility (mubah or ibahah). Later, such practices may be accepted by the Shari’ah,either by judgment as can be seen from the Hadith of Abu Hurairah above, or by tacitapproval. Thus, we find the legal maxim: “Custom (‘adah) is the basis of judgment” (al-adatu mu˙akkamtun). (Mejella Article 36).II. SHARI’AH NORMS AND PROHIBITIONS A. Distinctions from Conventional Insurance Takaful means “guaranteeing each other” in Arabic. Etymologically, its root comesfrom the Arabic “kafala;” which is, of course, one of Islamic Finance’s intermediatecontracts. It is a system of Islamic insurance based on the principle of mutual assistance(ta’awun) and donation (tabarru’) where risk is shared collectively by a group of participantsvoluntarily. This is a pact among a group of members or participants who agree to jointlyguarantee among themselves against loss or damage to any of them as defined in theircontracts. Shari’ah Norms. Takaful has 5 key elements that normalize it for Shari’ah purposes.They are self-explanatory, for the most part, and include:  Gratuitous mutual contributions and guarantee of losses divided between participants, i.e. in which case the participants are both the insurer and insured and all participants are aware that they face similar risks and are willing to contribute to the misfortune of any member.  Ownership of the Takaful fund and retaining mutual (versus private) ownership interests therein, including its profits. 6
  7. 7.  Avoidance of oppression (zulm), unfairness, injustice and exploitation (istighlal) and an understanding that their affairs are to be conducted openly in accordance with the utmost faith, good, honesty, transparency, truthfulness and equity.  Management of the Takaful fund through the use of Shari’ah-compliant contracts, e.g. mudharabah or wakalah.  Investment conditions necessitate that all investments must be Shari’ah-compliant; thus, prohibiting investment in impermissible or haram industries and requiring the use of investment instruments that are Shari’ah-compliant. Shari’ah Prohibitions. Conventional insurance contains three features that areprohibited by the Shari’ah. They are:  Major Uncertainty (Gharar Fahish): Transactions should be free from excessive uncertainty. Excessive, unacceptable uncertainty is caused by the lack of information or disclosure (jahl), which leads to ambiguity (taghreer), lack of “mutual consent” (ridha), misrepresentation (ghabn) or exploitation. Thus, making a contract of insurance unduly complex, verbose or combining within it, two or more other contracts, can easily lead to gharar. Misleading advertising and marketing (khalabah) can lead to misrepresentation and exploitation of the unwary. All or some of these characteristics in any commercial contract, including insurance contracts, can render the contract defective and thus voidable (fasid5). Voidable contracts can still be honoured and they may be reformed. This implies that they are not totally invalid, but there is language or provisions in them that are unacceptable to Shair’ah. It should be noted that more gharar is accepted in charitable, unilateral contracts (at-tabarru’at) than in purely commercial transactions. This latter Shari’ah principle buttresses the validity of Takaful contracts.  Gambling (Maisir or Qimar): Gambling is not permissible under Shari’ah. In gambling, one party is always hoping for a gain at the cost of another party loosing (qimar); the so-called “zero sum game.” Alternatively, one party may hope or “gamble” on a “windfall” or large gain with little or inordinately small counter-value (maisir). In the context of insurance, the policyholder hopes (bets) to gain a large sum from his small amount of contribution. What the policyholder actually hopes is that the claim will exceed his contribution. Thus, pooling of interests helps to avoid individual gain caused by individual greed or fraud. In this case, the company would probably be in deficit. However, the policyholder would lose the money paid for premium if the insured event does not occur, e.g. with certain so-called “term life” policies. These policies insure the life of the policyholder for a term of years; thereafter, the party is left uninsured if (s)he outlives the “term.” Furthermore, only a proportional refund would be made if the contract is terminated by the insurance company. Worse yet, some conventional policies demand payment of the entire premium for the initially insured period, even if the policy is terminated or forfeited by the insured. 5 Fasid means voidable in the majority of mudhahib (schools of religious law), but may mean invalid in the Shafi’ee madhab. 7
  8. 8. Interest (Riba): Any insurance contract wherein the policyholder expects to obtain a fix amount of profit that is greater than what he has contributed is considered as riba. That is because, by and between him or her and the insurance company, there is an exchange (and some might say an exchange of money), wherein one side lacks the equivalent counter-value or consideration. Other Shari’ah violations occur if the exchange is considered an exchange of money, and deemed bai’ as-sarf. Furthermore, investing premiums in financial instruments that are not Shari’ah-compliant usually involve prohibited elements of riba (e.g. interest) and maisir. Hence, the conventional insurance is prohibited under Shari’ah on a variety of grounds emanating from the prohibition against riba on all levels, i.e. shareholder, underwriting and investment funds. B. Shared Attributes with Conventional Insurance Certainly, Takaful is an adaption of customs that were prevalent before the advent ofIslam. It has never been said that Islam is the first religion, but rather the completion orfulfilment of that which came before it, in its pristine form (Qur’an 2:97). That said, the rootsof conventional insurance can be traced back to the Chinese. Around 5,000 BCE, Chinesetraders spread their merchandise over several ships, instead of putting all their property onone ship. If one ship sank, no individual trader bore the loss. If two traders spread theirgoods over two ships and one sank, each trader lost only half of his goods rather thaneverything (CGU 2004). The Babylonians, in the 3rd and 2nd millennium BCE, also engagedin insurance practices of risk transference and the latter codified such practices in the Code ofHammurabi, circa 1750 BCE6. These were early methods of transferring or distributing risk, practiced by Babylonianand Chinese traders and early Mediterranean sailing merchants. Similarly, if a merchantreceived a loan to fund his shipment, he would pay the lender an amount of interest muchhigher than the market average in exchange for the lenders guarantee. If the shipment wasnever received, the lender lost his money and the loan was considered cancelled (Ajmi 2005). As has been shown, both Takaful and conventional insurance have connection to theseearlier practices, though different epistemologically. However, one must make somedistinction between what is known conventionally as mutual insurance and what can becalled stock owned insurance. The former is owned by the participants (as in Takaful), whilethe latter is owned by 3rd party investors, whose primary motive for involvement with theinsurance company is profit. Table 1 illustrates the similarities and differences between the 2 models ofconventional insurance and Takaful. Dawood Taylor, Senior Regional Executive-TakafulMiddle East, of Prudential Corporation Asia, compared conventional mutual insurance withTakaful at the World Takaful Conference in Dubai in 2010. The primary difference betweenthe two models is the epistemological origins and the Shari’ah norms and prohibitions relatedto riba (Taylor 2010). Thus, it can be said that the differences with conventional insurancepractices is less significant with mutual insurance companies than with stock insurancecompanies.6 8
  9. 9. Table 1-Comparison Between Conventional Insurance & Takaful Characteristic Mutual Insurance Stock-Owned Takaful Insurance Contractual relationship Risk sharing by the Commercialized buy- Tabarru or unilateral policyholder-owners within sell or exchange gratuitous promise to the mutual company contract. contribute, combined at times with wakalah (agency) and/or mudharabah (partner) operator agreements. Economic goals Provide value to the Based on profit- Based on the motive of policyholders-owners. motive to maximize community welfare, protection Possible conflict of interest profit to shareholders. and mutual assistance; the between board, managers and An inherent conflict presence of a 3rd party operator policyholder-owners. of interest between or manager does not shareholders, circumvent that primary goal. managers and policyholders.. Governance Board of directors and Boards of directors SAC, Shari’ah advisory managers run the company "in elected by boards or committees and trust" for policyholders. shareholders; boards of directors. Operators, Policyholders have the right managers appointed as agents or partners must to appoint board of directors, by board. adhere to Shari’ah, and the board of directors governance and prudential appoints management. principles. Premium payments, surpluses Policyholders pay premiums Policyholders pay Contributions by participants & profits to the mutual pool; surpluses premiums, which are are gratuitous and pooled, but & deficits are allocated to the for specific insurance held in individual participant accounts of policyholders; and coverage over a special accounts (PSA); surpluses can be retained for specified timeframe; savings or investment feature reserves against future claims. premiums may may be present in family plans contain an investment and are placed in feature; surpluses and individualized participant income from accounts (PA); if no event investments belong to before maturity, participants the insurance receive the “balances” of their company and the PA, PSA and proportionately income from any valued share of surpluses; investment feature is surpluses are wholly owned by based upon a “fixed” participants unless wakalah annuity type contract. and/or mudharabah operators Taxes are paid on access as fees or profit profits and dividends sharing. Zakat is paid on to shareholders surpluses. Liability of Mutual pool is liable on Underwriting claims Claims are made from PA and Insurer/operator claims. are paid from PSA first. Then, from the premiums collected, Takaful fund; in the case of investment income deficits, qard hassan or a allocable to the benevolent loan can be made insurance company’s by an operator to the fund. capital or assets to provide the face value of coverage; insurance company may finance its activities with conventional debt or equity shares proceeds. Access to capital No access to share capital, but Insurance company’s Access to capital of operator possible use of subordinated capital is at risk. Debt through use of Qard Hasan. debt. may be used. Investment of funds No restrictions except for No restrictions except Resticted to Shair’ah- those imposed for prudential for those imposed for compliant investments, reasons. prudential reasons. including avoidance of gharar.(Adapted from Taylor 2010) Permission granted. It is instructive to note that many, if not most, mutual insurance companies in theWest have de-mutualized and become stock-owned insurance companies. Apparently all that 9
  10. 10. is needed is a majority approval by the policyholders and approval by the regulator. Suchlarge insurance companies as Liberty Mutual, New York Life, Metropolitan Life, JohnHancock and Prudential, all started out as mutual insurance companies, but weresubsequently de-mutualized (Rambeck 2001). This would appear to be an area of inquiry forresearch as Takaful grows and the most efficient models are compared, i.e. what makes oneform of operation more efficient or effective than another. Insurance is permissible in Islam when undertaken in the framework of Takaful ormutual guarantee and ta’awun or mutual cooperation. It is a pooling of unilateral promisesamong a group of people with common interests to protect and guarantee each other from acertain class of misfortune. It is based on sincerity and willingness of the group to helpanyone among them. The similarities with mutual insurance companies are remarkable.However, Takaful’s differences from conventional insurance are much starker whencompared to the commercialized aspects of stock-owned insurance companies. Theseconventional insurance companies offer and sell protection at a certain cost or price and forprofit. Each contract is individual and the private property of the policyholder and the actualowner of the policy may be someone who has an insurable interest in the inured person orproperty being insured. Because 3rd party investors and the managers they appoint may have the incentive tomaximize their profits at the expense of the policyholders, there is a stronger conflict ofinterests between shareholders of the insurer company and the policyholders. Moreover, thisagency problem may also cause managers of the insurance company, who may have bonusesor other forms of compensation tied to performance incentives, to minimize claim paymentsor benefits, or to raise premiums in order to maximize profits. Although Takaful funds do have 3rd party operators (who manage the fund on thebasis of wakalah or mudharabah), Takaful funds in Malaysia are subject to a regiment ofregulatory oversight and Shari’ah governance. Shari’ah governance is effectuated by thestandards applicable to Takaful funds promulgated by the Shari’ah Advisory Council (SAC)of Bank Negara Malaysia (BNM). The “Islamicity” of the fund is safeguarded further by itsown Shari’ah advisory committee or board, which functions at the fund level to insure thatproducts, services and operational activities are Shari’ah complaint. Moral hazards, whichmay arise in conventional insurance, are frowned upon in Takaful. Such moral hazards mayinclude the conflicts of interests discussed herein, agency problems, as well as zulm and otherunfair and undesirable features of commercial activities. Moreover, the emphasis placed onShari’ah governance in Malaysia particularly, illustrates the epistemological differencesbetween Takaful and conventional insurance.III. TAKAFUL IN MALAYSIA A. Evolution & Development In 1979, Sudan started the 1st Takaful fund, the Islamic Insurance Company of Sudan(Ajmi 2005), a little more than a year after a fatwa by the Saudi Arabian Council of HeadScholars (24/3/1977) denouncing conventional insurance contracts as being imbued withgharar. Later that same year, the Islamic Arab Insurance Company of Saudi Arabia wasformed. (Ernst & Young 2012). Malaysian scholars quickly followed in 1982 by denouncinglife insurance contracts. Malaysia was already well along the way to an Islamic financial 10
  11. 11. system, when in 1963, Tabung Haji became the first Islamic institutional investor. The firstTakaful fund was started in Malaysia in 1984, one year after establishing its first Islamic bank(Laldin 2008). The development of the Takaful industry in Malaysia in the early 1980s was inspiredby the prevailing needs of the Muslim public for a Shariah-compliant alternative toconventional insurance, as well as to complement the operation of the Islamic bank that wasestablished in 1983. It was, to a large extent, triggered by the decree issued by the MalaysianNational Fatwa Committee which ruled that conventional life insurance policies were fasiddue to the presence of gharar (excessive uncertainty), riba’ (usury) and maisir (gambling). ASpecial Task Force was established by the Government in 1982 to study the viability of thesetting up of a Takaful fund. Following the recommendations of the Task Force, the TakafulAct was enacted in 1984 and the first Takaful operator was incorporated in Malaysia inNovember 1984. Malaysian Takaful has experienced rapid growth and transformation since itsinception 28 years ago. It has grown from a single player with limited basic products to 12Takaful and 4 Retakaful operators; all integrated into the mainstream financial system. Thiswas achieved through the concerted efforts of Bank Negara Malaysia (BNM) and the Takafuloperators in developing a dynamic, resilient and efficient Takaful industry. In developingTakaful in Malaysia, BNM has adopted a gradual approach which can be divided into threephases as shown below. Phase I (1982-1992) started with the enactment of a dedicated regulatory law, theTakaful Act 1984 (still the only statute globally that is fully dedicate to Takafulundertakings), to govern the conduct of Takaful funds, and for the establishment of Shari’ahcommittees to ensure that the business operations of a Takaful operator are in compliancewith Shari’ah principles at all time, and the establishment of the first Takaful operator in1984–Syarikat Takaful Malaysia. The primary focus during this period was the establishmentof the basic infrastructure. Phase II (1993-2000) marked the introduction of competition with the entry ofanother Takaful operator–Takaful National Sdn. Bhd. This period also saw greatercooperation among Takaful operators in the region including the formation of the ASEANTakaful Group in 1995 and the establishment of ASEAN Retakaful International (L) Ltd. in1997. This has facilitated retakaful (reinsurance) arrangements among Takaful operators inMalaysia and in the region; namely Brunei, Indonesia and Singapore. It also saw theappointment of members of the National Shari’ah Advisory Council for Islamic Banking andTakaful. In addition to this, Takaful Malaysia and Takaful National (now known as EtiqaTakaful) jointly developed a Code of Ethics in 2000. Phase III (2001-2010) began with the introduction of the Financial Sector MasterPlan (FSMP) in 2001 which, among other objectives, is to enhance the capacity of theTakaful operators and strengthen the legal, Shari’ah and regulatory framework. The sectionof the (FSMP) which relates to Islamic banking and Takaful is a road map towards realizingthe aspiration of Malaysia becoming an international centre for Islamic finance. This periodhas so far witnessed an increased pace of development and competition with the licensing ofnew operators i.e. setting up of Ikhlas Takaful operator in 2002, issuance of four new Takafullicenses between 2005–2007. 11
  12. 12. To further promote the development of Takaful, the Malaysian Takaful Association(MTA), an association for Takaful operators, was established in 2002. The MTA aspires toimprove industry self-regulation through uniformity in market practices and in promoting ahigher level of cooperation among the players in developing the industry. Also, during this phase, the Malaysian International Islamic Financial Center (MIFC)was established in 2006 to develop intermediary linkages to the global market place. TheMIFC also promoted the liberalization of the Takaful Industry in 2009, which saw theissuance of 4 new family Takaful licenses in 2010. These new Takaful players addedsignificant value to Malaysia’s development of Takaful. Moreover, given the push for theintroduction of more stringent capital requirements, Malaysia has extended the discussion onrisk based capital (RBC) to Takaful. B. Current Status of Takaful in Malaysia Takaful is now a core segment of Malaysia’s status as a worldwide Islamic Finance“hub.” It is part of an “end-to-end” Islamic Finance system. Today, Malaysia has 12 Takafuloperators, 9 Malaysian (M) and 3 foreign-owned (F) owned:  AIA-AFG (F) Great Eastern (F) ING Public (F)  AmFamily (M) CIMB Aviva (M) Etiqa Takaful (M) Hong Leong MSIG (M)  HSBC Amanah (M) MAA Takaful (M) Prudential BSN (M) Syarikat Takaful (M) Takaful Iklas (M)Also, there are currently 4 Retakaful operators, 2 Malaysian (M) and 2 foreign-owned (F):  MNRB Retakaful (M) ARC Re Takaful SEA (M)  Munich Retakaful (F) Swiss Re (F) Worldwide there are less than 200 Takaful operators and less than 20 Retakafuloperators. Malaysia has 6 conventional life and general insurance companies; 2 areMalaysian and 4 are foreign-owned: Etiqa (M), MCIS Zurich (M), AIA (F), ING (F),Prudential Assurance (F) and Zurich Insurance Malaysia (F). There is 1 conventionalreinsurance operator and it is foreign-owned, i.e. Hannover Ruechversicherungs AG (F).However, as will be shown later, Malaysian Takaful contributions still lag far behindMalaysian conventional insurance premium. As can be seen, some of the conventional“players” have opened Takaful operations, utilizing their resources and insurance expertise toseize the Takaful opportunities. In Malaysia, Family Takaful is larger, but General Takaful is gaining traction. As of2011, Takaful contributions were about .6 of 1% of Malaysia’s Gross National Income andapproximately 10% of total insurance premiums (BNM 2012). Worldwide, Takaful is aprojected $12 billion dollar industry in 2012, according to the most recent Ernst & Young(E&Y) World Takaful Report; after being $8.3 billion in 2011 (after adjustment for inflation).Conventional insurance worldwide is a $4.6 trillion dollar industry by comparison (Ernst &Young 2012). 12
  13. 13. C. Business Models Takaful operators use several different models to fulfill their roles as providers ofTakaful. The primary models are named after their underlying secondary contracts under theIslamic Finance system. They include tabarru, wakalah, mudharabah, waqf and the hybridmodels (Alhabshi 2012). Tabarru (Donation) -Based Takaful. The tabarru-based Takaful is the most idealmodel of Takaful among other models. Initially, Takaful was seen as a non-profit orientedactivity. This model is based on solidarity, responsibility and brotherhood amongparticipants. In this model, each participant is willing to make donation to the Takaful fundwith sincere intention to extend financial assistant to other participants faced with difficulties.It provides no return for both the Takaful operator and the participants. Therefore, such modelis viewed as impeding large-scale expansion of Takaful business (Ibid). Mudharabah-Based Takaful. Mudharabah is an Arabic term that comes from darbfil-ard, meaning to journey through the earth seeking the Bounty of Almighty Allah. Underthis model, the participants make contributions that are credited to a participants’ fund, whilethe shareholders of the Takaful operator company contribute to a shareholders’ fund which isdifferent from the participants’ fund. The Takaful operator, as mudharib, invests theparticipants’ fund in Shari’ah-compliant instruments. Profits generated from the investmentare shared between the participants and Takaful operator in the agreed ratio. Any losses arecharged to the participants’ fund. In a mudharabah concept, operational expenses relating toinvestment are charged to the shareholders’ fund. In managing the operations, general andadministrative expenses other than relating to investments are charged to the participants’fund. As valid claims are made, Takaful benefits are paid to beneficiaries depending uponoccurrence of actual losses and damages. In case of surplus, the participants receive fullrefund, but have to make additional contributions if a deficit exists (Ibid). Wakalah-Based Takaful. Under the wakalah-based model, the Takaful operatorperforms as the wakil or agent of the participants and is consequently entitled to a fee for theservices provided. In theory, the participants’ contributions are credited to a participants’fund. As an agent, the shareholders of the Takaful operator company donate to ashareholders’ fund which is maintained separately from the participants’ fund. The Takafuloperator invests the participants’ fund in Shari’ah-compliant instruments in its capacity aswakil or agent. All operational general and administrative expenses are charged to theparticipants’ fund. The Takaful operator receives an agency fee from a percentage of thegross contributions received. As valid claims are occurred, the benefits are paid to theparticipants depending upon occurrence of actual losses and damages. Any underwritingsurplus is given back to the participants. And the participants are required to make additionalpayment of deficit if any (Ibid). Waqf Model. Under this model, a waqf can be established by the Takaful operatorthrough the contribution of a “ceding amount” (part of the capital) to compensate thebeneficiaries or participants of a Takaful scheme. The ceding amount of the waqf will remaininvested. The Takaful fund, consisting of the contributions paid as tabarru’, will be furtherinvested by the operator in accordance with Shari’ah. Any person by signing the proposal for,contributing to the waqf and subscribing to the Takaful documents, shall become a member ofthe waqf. The waqf will become owner of all contributions and has the right to act as a legal 13
  14. 14. entity as per its terms for investment, compensation and dealing with the surplus amounts.The Takaful wakil, while managing the waqf fund, will play two different rolessimultaneously: operator/manager and trustee (Ibid). Hybrid Model. The hybrid model combines elements of the wakalah andmudharabah models and is set so that the Takaful operator has two funds; one for theshareholders and the other for participants. In this model, a wakalah contract is used forunderwriting activities while mudharabah contract is used for investment activities. Withregard to underwriting activities, the Takaful operator acts as wakil or agent on behalf ofparticipants to manage their funds. In exchange for managing the funds, the Takaful operatorreceived a fee known a wakalah fee of agency fee which is normally a percentage of thecontributions by participants. An incentive fee is provided to the Takaful operator if there is asurplus in the participants fund as a result of managing the fund effectively. Generally, anysurplus contributions will be invested in different Islamic instrument based on mudharabahcontract, which the Takaful operator acts as mudharib on behalf of participants (capitalprovider). Like other mudharabah contract, the ratio of profit is fixed and agreed uponbetween the two contracting parties (Ibid). D. Malaysian Classifications Takaful in Malaysia is broadly divided into Family and General Takaful. Family Takaful Business. A Family Takaful plan is a combination of long-terminvestment and a mutual financial assistance scheme. The objectives of this plan are asfollows:  To encourage saving on a regular basis over a fixed period of time.  To earn investment returns in accordance with Islamic principles.  To obtain coverage from a mutual aid scheme in the event of death of the participant prior to maturity of the plan. The contribution paid by the participant is credited into two separate accounts, namely theParticipants’ Special Account (PSA) and the Participants’ Account (PA). The portion of thecontribution that goes into the PSA is based on the tabarru’ or donation concept. The amount isactuarially determined based on the age and overall health of the participant and the cover period.The older the participant, the higher will be the portion of the tabarru’. Similarly, the longer theperiod of coverage, the higher is the tabarru. The balance of the contribution after deduction fortabarru goes into the PA account, which is meant for saving and investments only. The participants contribution that goes into the PSA will be used to fulfill the obligationof mutual help should any of the participants face misfortune arising from death or permanentdisability. If the participant survives to the date of maturity of the Takaful plan, he or she will beentitled to share the net surplus from the fund, if any. The fund in the PA account will be investedby the Takaful operator. The profit from the investment will be shared between the participantsand the operator according to a pre-agreed ratio (Ibid). General Takaful Business. The General Takaful scheme is essentially for mutualfinancial assistance on a short- term basis, usually 12 months. The scheme is mainly to allowparticipants to be compensated for any material loss, destruction or damage to their properties orbelongings by some mishap or misfortune. Under this concept, all the contributions made by theparticipants are placed in the General Takaful fund on the basis of tabarru or donation. This isquite different from Family Takaful where the contributions of the participants are divided and 14
  15. 15. credited into two separate funds, the PSA and the PA. If at the end of the Takaful period, a netsurplus exists in the General Takaful fund, the same shall be shared between the participants andthe operator on the basis of mudharabah (profit sharing), provided the participants have not madeclaims or received benefits in excess of contributions. The main types of General Takaful schemeprovided operators are: 1. Home Takaful scheme. 2. Motor Takaful scheme. 3. Marine, aviation and transit Takaful schemes. 4. Accident /miscellaneous Takaful scheme, which includes: (a) Personal accident scheme. (b) Workmen compensation Takaful scheme. (c) Engineering Takaful scheme (Ibid). E. Taxation in Malaysia It should also be noted that in Takaful, zakat should be paid on any surplus; regardlessof whether the fund is otherwise subject to income taxes. Generally, companies are taxed inMalaysia as residents, if the management and control of the company is based in Malaysia.Control, for tax purposes, is demonstrated by the holding of statutory board meetings inMalaysia which concern management and control of the company. Resident companies withpaid-up capital of RM 2.5 million or less are taxes at a flat 20% rate for the first RM500,000of chargeable income and a flat 25% rate for chargeable income in excess thereof (PWC2012). Non-resident companies are taxed at a flat 10% rate on royalties, rental income onmoveable properties and technical or management service fees rendered in Malaysia. A 15%rate applies to interest income that is not exempt. Interest income is exempt if paid by a bankor finance company in Malaysia or paid on loans granted or guaranteed by the government ofMalaysia. Single tier dividends are exempt from tax, while other dividends are taxed at 25%,as is business income. All other income is taxes at a flat 10% rate. Tax on income taxed by aforeign country may be reduced. Non-resident income and related taxation may be subject toany number of tax treaties (Ibid). Dividends paid, credited or distributed by cooperative societies to their members areexempt from taxation. A co-operative society must be registered. Co-operative societies arenot exempt from taxation themselves. 2012 legislation exempts interest income on co-operative society deposit balances of up to RM100,000. Moreover, there are limiteddeductions and exemptions from taxation, in addition to the incentive noted below, asfollows: • A deduction up to a maximum of 25% of net income for contribution to statutory reserve fund required to be created under the Cooperative Society Ordinance (Public Ruling No. 9/2011 limits this deduction for additions to reserves to 25% of audited net profits for the year). • An amount equal to 8% of the members funds (Public Ruling No. 9/2011 limits this amount to 8% of the member funds at the beginning of the year and further defines what balances are included in the term “member funds”). 15
  16. 16. • Tax exemption for a period of 5 years from the date of registration is allowed to enable new cooperative societies to establish themselves during the initial stage of establishment. • After the 5th years, cooperatives having members’ fund of RM750,000 or less will continue to be tax exempted (Laws of Malaysia, Act 533). Moreover, the primary incentive given to Takaful operators in Malaysia, is that ofexempting them from taxation for the years ending 2007 through 2016, for all income fromTakaful operations conducted in international currencies, provided the Takaful company orunit is licensed under the Takaful Act of 1984. There is also an exemption from stamp dutiesfor co-operative societies for tax years beginning 2012 if the transaction being stamped is incompliance with the Shair’ah. Finally, any company designated a Kuala LumpurInternational Finance Centre company, is exempt from taxation for a 10 year period andexempt from stamp duties for loans done therein. The Co-operative Society Act of 1993 (the Act), Part II, Section 4 defines a co-operative society as: “A society which consists of individual persons only and which has as its object the promotion of the economic interest of its members in accordance with co- operative principles may be registered under this Act as a primary society.” (Laws of Malaysia, Act 502). A society that consists of two or more primary societies only and whose purpose isthe facilitation of the purposes of the primary societies may be registered as a secondarysociety. Similarly, a tertiary society is one that consists solely of two or more secondarysocieties. A primary society must consist of at least 100 qualified individual members.Exception for certain smaller co-operatives may be granted upon approval. The Actspecifically states that one of its purposes is “to encourage and promote the establishment anddevelopment of co-operative societies in all sectors of the economy and to help co-operativesocieties increase their efficiency.” Cooperative societies are specifically referenced in theTakaful Act of 1984 as a mode of operation (Laws of Malaysia, Act 502). According to the Malaysia Co-operative Societies Commission: “The cooperatives with financial and banking functions have pioneered the development of cooperative movement since the 1920s. These cooperatives conduct financial activities such as providing loans to members at reasonable interest rates. Other activities under this function are Islamic mortgage (Ar- Rahnu), investment and insurance services. The members comprise those with regular salary income, especially in the public sector, statutory and private bodies. Currently there are two specific cooperatives which are carrying out banking functions, namely Bank Kerjasama Rakyat Malaysia Berhad and Bank Persatuan Malaysia Berhad.” REGULATORY OVERSIGHT & STANDARD SETTING A. Legislative History Malaysia’s Takaful Act 1984 is presently the world’s only specifically enactedlegislation governing the operation of Takaful funds. The laws governing Takaful vary from 16
  17. 17. one country to another. In other countries Takaful is subject to the existing laws applicable tothe insurance industry. Malaysia’s legislation recognizes Takaful as possessing uniquecharacteristics which justify an independent regulatory framework. One of the importantfeatures of the Takaful Act 1984, which is not provided in conventional insurance, is therequirement for the establishment of Shari’ah supervision. In order to ensure compliance with Shari’ah principles, the Takaful operators arerequired to observe the following at the company, as well as national, level:  The requirement to set up a Shari’ah supervisory board or Shari’ah committee within the company, which advises the management to ensure that their activities fully comply with Shari’ah principles.  At the national level, the National Shari’ah Advisory Council on Islamic Banking and Takaful was set up at Bank Negara Malaysia (BNM) to advise on the Shari’ah aspects of the operations as well as approval of various products and services. The Takaful Act 1984 can be divided into four parts: Part I: This provides for the interpretation, classification and references to Takafulundertakings. Takaful is divided into two broad categories, namely General Takaful andFamily Takaful. Those who enter the plans are called Takaful participants, as opposed toparticipants. Part II: This provides the mode and conduct of Takaful undertakings, e.g. restrictionon the usage of the word “Takaful,” conditions of registration, restrictions on Takafuloperators, the establishment and maintenance of Takaful funds and allocation of surplus, theestablishment and maintenance of a Takaful guarantee scheme fund, requirements relating toTakaful, and other miscellaneous requirements on the product of Takaful business. Part III: This part specifies the powers vested in BNM and the appointment of itsGovernor as the Director-General of Takaful in regulating Takaful undertakings, the powersof investigation of BNM and provisions for the winding-up and transfer of business of aTakaful operator. Part IV: This provides for the administration and enforcement of matters such asindemnity, submission of annual reports and statistical returns, offences and prosecution ofoffences. The Takaful Act 1984 was adapted from the Insurance Act 1963 and sections of thatAct were deemed non-Shari’ah complaint and were deleted; others were altered to complywith Shari’ah requirements. The Insurance Act 1963 was subsequently repealed and replacedwith the Insurance Act 1996. Under the Takaful Act 1984, a Takaful operator must be incorporated as a company asdefined in the Companies Act 1965 or as a society as registered under the Co-operativeSocieties Act. The operator must have the required deposit and pay annual registration fees.Moreover, it must maintain at all times surplus of assets over liabilities of not less than theamount as may be prescribed from time to time. The Act requires that the objectives andoperations of the Takaful business must adhere to the tenets of the Shari’ah and must not mixits operations with any prohibited activity under the Shari’ah. B. Bank Negara Malaysia (BNM) BNM, in order to spur the growth of Takaful, has forged certain guidelines. Theyrevolved around capital adequacy, financial reporting, anti-money laundering and prudential 17
  18. 18. limits and standards. It has elaborated and researched various issues which are faced byTakaful companies and has issued guidelines to facilitate the operation of Takaful funds.Some of these guidelines are:  Guidelines on Directorship for Takaful Operators  Guidelines on Prohibitions against unfair practices in Takaful Business  Guidelines on Claims Settlement Practices  Guidelines on proper advice for Family Takaful  Guidelines on Operating Costs of Family Takaful. Source: Bank Negara Malaysia’s Shari’ah Governance Framework Finally, BNM, in October 2010, implemented a Shari’ah Governance Framework(SGF) that requires all Islamic financial institutions, including Takaful funds, to establish aSGF. In addition to the Shari’ah advisory board requirement noted above, Takaful funds arerequired to either employ internally, or to contract with external Shari’ah advisory firms thatwill deliver a Shari’ah: (1) risk management control function; (2) review function; (3)research function; and (4) audit function. Figure 1 illustrates the SGF. 18
  19. 19. Of particular note in the SGF is the critical role of the Shair’ah Audit and Reviewfunctions. BNM defines a “Shair’ah Audit” as: “Shariah audit refers to the periodical assessment conducted from time to time, to provide an independent assessment and objective assurance designed to add value and improve the degree of compliance in relation to the IFI’s business operations, with the main objective of ensuring a sound and effective internal control system for Shariah compliance.” (BNM 2010). The Accounting and Auditing Organization for Islamic Financial Institutions(AAOIFI) defines the “Shari’ah Review” function as: “The primary objective of the internal Shariah review (carried out by independent division or part of internal audit department) is to ensure that the management of an IFI discharge their responsibilities in relation to the implementation of the Shariah rules and principles as determined by the IFI’s Shariah Supervisory Board (SSB).” (AAOIFI, Governance Standard for IFI No.3). C. Islamic Financial Services Board (IFSB) In 2006 the IFSB and IAIS wrote a paper titled “Issues in Regulation and Supervisionof Takaful” which deals with the application of the IAIS core principles needed toaccommodate Takaful such as corporate governance, financial and prudential regulations,transparency, report and market conduct and supervisory review process. In November 2009, the IFSB issued the “Guiding Principles on Governance forTakaful Undertakings.” In December 2009, it issued IFSB-11, entitled “Standard onSolvency Requirements for Takaful Undertakings,” which establishes solvency rules forTakaful operators consistent with Solvency II (ISRA 2011). The main objective of thisstandard is to emphasize capital adequacy and give confidence in the sustainability of theTakaful market. There are other relevant standards, such as: “Guiding Principles on Conduct ofBusiness for Institutions offering Islamic Financial Services,” “Guiding Principles onShari’ah Governance Systems for Institutions Offering Islamic Financial Services,” and a“Guidance Note on the Recognition of Ratings by External Credit Assessment Institutions onTakaful and Retakaful Undertakings” which buttress and underpin the growth of Takafulthroughout the world. Recently, the IFSB issued its Exposure Draft on Standard for “RiskManagement for Takaful (Islamic Insurance) Undertakings” (IFSB 2012). D. Accounting Association of Islamic Financial Institutions (AAOIFI) AAOIFI since its inception in 1991 has issued 81 standards, in which 4 standards arerelated to Takaful (Shahul 2009). They are as follows: 1) FAS 12- General Presentation and Disclosure in the Financial Statements of IslamicInsurance Companies. Basically, it deals with the following components:  Complete set of financial statements, including statement of participants’ surplus (or deficit), and sources and uses of Zakah and charity funds;  General disclosures including those on earnings or expenditure prohibited by Shari’ah; and  Treatment of changes in accounting policies, changes in accounting estimates etc. 19
  20. 20. 2) FAS 13- Disclosure of Bases for Determining and Allocating Surplus or Deficit inIslamic Insurance Companies. It has the following components:  General disclosures on contractual relationship between participants and insurance operations manager;  Disclosure on accounting policies regarding the party that meets general and administrative expenses; and  Disclosures on allocation of profit generated from investment of participants’ funds; and on treatment of current deficit and/or cumulative deficit. 3) FAS 15- Provisions and Reserves in Islamic Insurance Companies. It contains:  Accounting rules for technical provisions such as unearned contributions provisions, outstanding claims, and claims incurred but not reported;  Accounting rules for deficit reserves and equalization reserves; and  Recognition, measurement, and presentation of those provisions and reserves; and disclosures on basis for determining provisions and reserves. 4) FAS 19- Contributions in Islamic Insurance Companies. It provides for:  Recognition, measurement, and presentation for contributions made on the basis of donation by participants;  Disclosure on accounting policies for treatment of contributions;  Disclosure on accounting policies for withdrawal of policyholder and cancellation of insurance policy; and  Presentation of Statement of Participants Revenue and Expenses. Furthermore, all standards are reviewed. Review is to take into account, amongstothers, current market practices, prevailing conventional international standards, andinternational best practices. And the review is to be carried out in consultation with theindustry experts. E. Role of Shari’ah Boards & Committees The general responsibilities of a Shari’ah Board or Committee are as follows:  Ensuring that both the shareholders’ and Takaful funds are handled and administered in accordance with the Shari’ah tenets;  Catering expertise and guidance for the company in all matters pertaining to the Shari’ah principles, its structure and investment process, and other operational and administrative issues;  Consulting the authorities who may consult their Shari’ah Advisory Council where there is any ambiguity regarding to investment, instrument, system, procedure and process;  Scrutinising the company’s compliance report as provided by the compliance officer, transaction report provided by or duly approved by the trustee and any other report deemed necessary for the purpose of ensuring that the investments are compatible with the Shari’ah precepts;  Preparing a report to be included in the company’s annual report certifying whether the Takaful business has managed in accordance with the Shari’ah principles;  To make sure that the Takaful undertaking complies with any guideline, ruling or decision issued by the authorities with regard to Shari’ah matters; 20
  21. 21.  Vetting and advising on the promotional materials of the company; and  Assisting and attending to any ad-hoc meeting called by the authorities or any other relevant authority (CIFP, op.cit.). F. Fatawah The first fatwa prohibiting conventional insurance in its modern form was rendered byIbn Abdeen, a Syrian scholar in 1834 (Khan 2008). As noted earlier, the modern prohibitionbegan in Saudi Arabia (1977), followed by fatawah in numerous Islamic countries, includingMalaysia (1982). Since then, there have been numerous fatawah or Shari’ah rulings on thevarious practices surrounding Takaful (some of which are referred to as resolutions, whenissued by Shari’ah boards or committees). Resolutions do not carry the same legal strength asfatawah, but for purposes of this paper, they are grouped under that heading for illustrationpurposes only. Figure 2 list the primary sources of them. Figure 2 • 19 wide ranging “Resolutions” pertaining to Takaful, Bank Negara including Takaful Models, Takaful coverage for Malaysia’s conventional Loans, Segregation of Takaful funds, SAC distribution of surplus from the PSAs, provision of reserves, etc. Kuwait • 15 Fatawah with respect to Takaful, including health & Finance medical plans, auto insurance, protection against vandalism, insurance of debt, insurance on cash balances, insurance on House investments, etc. OIC Fiqh • Fatawah on health insurance, various aspect of insurance Academy and use of reinsurance in the absence of retakaful operators. Summary of Fatawah on Takaful and Retakaful summarized from www.isra.myV. RISK ATTRIBUTES OF TAKAFUL A. Risk Profile. Takaful, though socio-religious in its epistemology, isnonetheless in the “business” of identifying, measuring & managing risks through avoidance& transference techniques. Some risks are endemic to Takaful, e.g. the reputational riskassociated with Shari’ah compliance. Other risks are entity or firm level, e.g. those that mightbe affected by the underwriting classes of a particular Takaful undertaking. Other risks aresystemic and affect the entire insurance industry. Some authors classify Takaful risks aseither “pure” or “speculative.” Pure risks, according to them, are those risks that have only 2possible outcomes, i.e. loss or no loss and there is no possibly of gain. Speculative risks, theyaver, are those in which the uncertainty about the risky event could result in either gain orloss (Obaidullah 2005). 21
  22. 22. Such taxonomies remind us that Takaful undertakings are inherently risky and thatrisk of loss is ever imminent. Almighty Allah reminds us of the inevitability of (risk) byidentifying two forms of disaster (museebah): “And we shall surely test you with something of…loss of wealth and lives…but give good tidings to the patient, who when disaster (museebah) strikes them, say, ‘indeed we belong to Allah, and indeed to Him we will return.’” (2:156-57). Malaysia does have a better risk profile than other ASEAN nations when it comes tonatural disasters; being identified as high risk only in the area of floods (ASEAN 2011). Andat the moment anyway, Southeast Asia is less volatile politically than the Middle East andNorth Africa (MENA) region. Yet, some risks simply are virtually unmanageable. In a worldmarked by terrorism, ideological conflict, war, natural disasters, political unrest, ecologicaldisasters and technological errors, now, possibly more than ever before, the single mostdangerous risk is pure risk. However daunting the task, Takaful, like its counterpart, insurance, must classify itsrisks. The IFSB, which is based in Malaysia, is presently grappling with this very issue. Asnoted earlier, the IFSB recently (November 2012) issued its Exposure Draft on “RiskManagement for Takaful Undertakings.” The taxonomy of Takaful risks is presented thereinas follows:1. Reputational and Regulatory Risks associated with Shari’ah non-compliance,caused by-  Breach of Shari’ah principles in its contracts  Differences in perceptions of Shari’ah compliance emanating from varying interpretation of Fiqh Muamulat by Shari’ah scholars and differences in jurisdictional practices worldwide  Increased competition and pressure to develop innovative products that are non- compliant  Limited availability of Shari’ah-compliant investment instruments could lead to questionable practices  Separation of participant funds (both risk and investment designated) and shareholder funds in the mudharabah and yadd damman models and the concomitant agency risks and vigilance in the areas of fairness and transparency  Inability to mitigate risks through diversification between stakeholder funds can result in higher economic capital requirements  Qard mechanisms and risks associated with the requirement to make these loans to participants, as well as the risk associated with their inability to repay them  Mis-segregation and mis-allocation of income and expenses between stakeholders  Misaligned underwriting costs and expenses resulting in the inability to meet the requirements of the underlying contracts  Reinsurance and other risk transfer difficulties associated with excess exposure concentrations or connected counterparties  Risks associated with the both the polemics over the legitimacy of using reinsurance vis-à-vis retakaful, as well as the attribution of funds under both, e.g. the payment of commissions as opposed to actual risk sharing arrangements 22
  23. 23.  Credit risk exposure from retakaful contracts and the quality of risk selection and pricing, requiring due diligence and good governance2. Specific Risks of Particular Relevance to Takaful- A. Operational risk or the risk of loss resulting from inadequate or failed internal controls, people or systems; or from external events. It may also include the Shari’ah risk of operators failing to meet their fiduciary duties. These risks may result in:  An inability to pursue opportunities, inefficiency and threaten business continuity  Breach of fiduciary duties  Underwriting “management” risk or failure to properly managed the contributions by participants  Negligent, incompetent, fraudulent or criminal activities  Failure of information technology systems  Failure to be vigilant in monitoring outsourced activities, particularly as related to Shari’ah norms and prohibitions B. Underwriting risk is the risk of loss due to underwriting activities, includingassumptions used in pricing and assessment, later found to be incorrect, and may result in-  Failure to identify changes in expected and actual claims experience, including mortality and morbidity, so as to acknowledge trends in claims and settlement costs and needed changes in underwriting standards, policy provisions and pricing.  Faulty expense assumptions, including remuneration.  Increased lapses in policies and lack of persistency in renewals and new participant contributions, all of which may affect risk pool volatility.  Monitor deficiencies or failures to collect on Qard, which may be linked to perceptions of poor underwriting management; unlike conventional insurers, Takaful funds can only repay these losses out of future surpluses and not new contributions.  Unacceptable concentration risk levels related from positive correlations between risk pools underwritten and failure to transfer such risks to Retakaful plans.  Increased provisioning risk, which relates to level of reserves to meet future claims and claims being processed.  Increased provisioning risk caused by failure to properly project losses by underwriting and loss year and failure to reassess projection methods periodically.  Misperceptions created in the minds of participants as to minimum levels of returns on Family investments or surplus distributions (participant reasonable expectations)  Mis-management of co-Takaful arrangements and under provisioning of related claims. C. Market risk is the risk of losses arising from movements in market prices, i.e.fluctuations in values of leases, sukuk and other investments and deviation of actual returnsfrom expected returns. This risk may lead to-  Deficits in reserves and inadequate performance.  Failure to adopt investment strategies by investment instrument that quantify the impact of fluctuations and are based on the ability to absorb fluctuations.  Failure to hedge in order to dampen such fluctuations by asset class. 23
  24. 24.  Failure to align asset-liability management to create cross-subsidy between funds being managed by one Takaful operation. D. Credit risk is the risk that a counterparty fails to meet its obligations, resulting inmisalignment of operational, financing and investment activities, caused by-  Failure to provide for viable Retakaful relationships and to manage the provision of coverage on General Takaful extended on a credit basis.  Failure to identify, measure and manage investment risks by asset class and fund exposure.  Failure to manage Qard during growth periods or following major losses through capital adequacy. E. Liquidity risk is the risk of loss arising from an inability to meet impendingobligations or to fund increases in assets as they fall due without incurring unacceptable costsor losses that may cause-  Inability to dispose of assets in an orderly manner, in time to cover claims or withdrawals, or to pay debts in a timely manner; all of which may lead to the loss of confidence, reputational damage, uncontrolled withdrawal, litigation or regulatory action.  Inability to pay wakalah fees and to distribute surpluses.  Possible Qard drawdowns.  Inability to service debts related to PP&E acquisitions, fees for underwriting, etc.  Failure to implement, monitor and manage liquidity policies, including the failure to plan for and have contingency plans to address shortages in internal and external financing sources. F. Legal and Compliance risk is related to the legal and regulatory implications ofoperational activities, disputes and contractual difficulties, which may cause-  Unethical behavior, including poor handling of agency conflicts.  Failure to reconcile conflicting interests pursuant to IFSB-8.  Non-compliance with jurisdictional laws and regulations, which may be the result of the failure to implement compliance review procedures.  Criminal activity, fraud and breach of international sanctions; all of which may damage the reputational risk of the Takaful fund (IFSB Exposure Draft No. 14). B. Risk Intermediation. Underwriting is the traditional tool used in insurance risk intermediation. It is definedby the International Insurance Institute as “(e)xamining, accepting, or rejecting insurancerisks and classifying the ones that are accepted, in order to charge appropriate premiums forthem.” Takaful operators adapt the underwriting process to determine contribution rate (inlieu of premiums) using three stages:  Gathering Information;  Classifying risks, e.g. preferred, standard, rated, postponed or declined in life policies; and  Determination of a contribution rate (Alhabshi op.cit). The recent IFSB Exposure Draft-14 indicates that a risk management framework(RMF) should be established, which is comprehensive in nature, contains a set of consistently 24
  25. 25. applied policies and strategies and encompasses the Takaful’s appetite for risk, its processesfor managing them and the governance thereof. The policies typically address the issues ofrisk retention, retakaful, Shari’ah-compliant hedging techniques and regulatory capitaladequacy requirements. Emphasis is given to the process of identifying as many foreseeablerisks as possible with an eye towards new and emerging risks. In addition to risk policies andstrategies, the RMF should contain a risk register, as well as risk identification processes andrisk assessment, response and control procedures. The Exposure Draft further recommends an internal control framework covering thekey activities of the Takaful, encompassing risk detection and prevention controls of either amanual or automated nature. Takaful undertakings are further advised to establish riskmonitoring information systems with comprehensive reporting capabilities. These controlsshould be embedded in daily operations (1st line of defense), independent monitoring, thereview of the risk management mechanism (2nd line of defense) and an independent assuranceor audit function (3rd line of defense). Finally, the RMF should have an asset-liability management (ALM) functionality,which monitors assets and liabilities for mis-matches, divergence of actual and expectedlevels of returns, misaligned risk-returns, liquidity requirements and embedded options incontracts, e.g. settlement options, policy loan options, over-depositing options and surrenderor renewal privileges (all of which could result in additional costs). External factors andchanges in business composition and direction should also be considered (IFSB op cit). Given Malaysia’s leadership in regulatory oversight in the Takaful and IslamicFinance arenas, as well as its strong alliance with the IFSB, Malaysia is strategicallypositioned to continue to play a leadership role in the global Takaful market. That said, whatwill continue to be her greatest challenge will be to manage the risks inherent in Takaful,while adhering to the social principles upon which Takaful is founded. One such challengewill be to devise innovative ways to make Takaful affordable to the widest possible numberof her citizenry. C. Retakaful Takaful operators may transfer risks to larger operators. This is generically calledreinsurance, or retakaful in Islamic Finance. Reinsurance is defined as: “Insurance bought byinsurers. A reinsurer assumes part of the risk and part of the premium originally taken by theinsurer, known as the primary company. Reinsurance effectively increases an insurers capitaland therefore its capacity to sell more coverage. It also allows Takaful funds to shift ortransfer their larger risks to these companies, who accept these risks from a diversified list ofprimary companies; thus, spreading the risk through their auspices, which could nototherwise be intermediated by a single Takaful operator. The retakaful is global and someof the largest reinsurers are based abroad. However, Malaysia is home to 2 of these largeretakaful operator’s subsidiaries, i.e. Munich Retakaful and Swiss Re. Reinsurers have their own reinsurers, called retrocessionaires. Reinsurers don’t paypolicyholder claims. Instead, they reimburse insurers for claims paid. They do so under 2methods:• Facultative. A reinsurance policy that provides an insurer with coverage for specific individual risks that are unusual or so large that they aren’t covered in the insurance company’s reinsurance treaties. Examples are coverage for jumbo jets or oil rigs. 25
  26. 26. • Treaty reinsurance. A reinsurer agrees to assume a certain percentage of an entire classes of business, e.g. as various kinds of general Takaful, up to preset limits.Retakful operations are structured on the tabarru’ basis. They take contributions fromparticipating Takaful operators, who share in the risk pools. Retakaful operators primarily usethe wakalah and mudharabah models. The wakalah fee is usually paid up front and runsapproximately 5% for acting as wakil over the pooled fund. The mudharabah shares in theprofit from managing the investments of the pooled fund as the mudharib partner. The profitpercentage may vary but ARC, for example, charges 40%7. Malaysian Takaful operators, on average, ceded about 20% of their commissions toretakaful in 2011. That compares with roughly 34% in the GCC. The disparity is explainedby operators as being due to the GCC Takaful concentration in General Takaful vis-à-vis theirMalaysian counterparts (Ernst & Young 2012). Retakaful operators in Malaysia provide Qardfacilities to the Takaful participants in their funds. There exists a shortage of retakaful operators worldwide; although it is less ofproblem in Malaysia because of the presence of 4 retakaful operators. This has resulted insome discussion over the permissibility of using reinsurance in lieu of retakful. This issuewas largely resolved when the OIC Fiqh Academy in its 1985 fatwah, stating: “The Councilencourages Muslim countries to establish cooperative insurance and reinsurance institutions.This is so that Islamic economics would be liberated from exploitations and violations of thesystem that Allah has chosen for this ummah.” Accordingly, absent an apparent weakness in aretakaful or mutual or cooperative reinsurance company, e.g. failure to meet capital adequacyrequirements, etc., if there is a need to turn to the reinsurance market, the Takaful operatorshould first try and obtain coverage from the retakaful, cooperative or mutual insurancesector (Ismail 2009). D. TIPS Malaysia has a Takaful and insurance benefits protection system (“TIPS”) as a limitedprotection system to cover both Takaful and insurance benefits. TIPS the acronym forPerbadanan Insurans Deposit Malaysia (“PIDM”), an independent statutory body establishedunder the Malaysia Deposit Insurance Corporation Act 2011 (Act). Its stated purposes are to: • Administer a deposit insurance system and a Takaful and insurance benefits protection system under the Act; • Provide insurance against the loss of part or all of deposits for which a deposit taking member is liable and provide protection against the loss of part or all of Takaful or insurance benefits for which an insurer member is liable; • Provide incentives for sound risk management in the financial system; and • Promote or contribute to the stability of the financial system.PIDM collects premiums from member Takaful and insurance companies. The premium ratesare determined actuarially by the Malaysia Deposit Insurance Corporation (MDIC). TIPSmanages and segregates different funds into pools, as follows: • Family solidarity Takaful protection fund; • General Takaful protection fund; • Life insurance protection fund; and 7 26
  27. 27. • General insurance protection fund.There is no comingling of incomes or expenses between any of TIPS funds. There are limitson the coverage provided by TIPS. The schedule of coverage benefits can be viewed at FINANCIAL ATTRIBUTES OF TAKAFUL A. Financial Intermediation One of the common features Takaful shares with conventional insurance is the role itplays in financial intermediation. “Financial intermediation is a productive activity in whichan institutional unit incurs liabilities on its own account for the purpose of acquiring financialassets by engaging in financial transactions on the market; the role of financial intermediariesis to channel funds from lenders to borrowers by intermediating between them.” (Retrievedfrom While the above definition may be more suited for conventional insurance providers,its application to Takaful, once modified, still applies; notwithstanding Takaful’s motivationof mutual protection and shared responsibility. (Engku Ali 2008). In short, modern financialexigencies give Takaful little choice but to incur a liability (notwithstanding the charitabledonation character of participant contributions) on behalf of its participants, by collectingcontributions from them, and in turn, investing the net of those proceeds in a Shari’ah-compliant manner in the marketplace in anticipation of fulfilling the future obligations to itsmembers. This is the essence of the economic activity known as the “intermediation effect”(Smith 1978), or simply put, financial intermediation. Insurance has been causally connected to economic growth in developed countriesand anecdotally believed to be an economic driver in others through job creation, riskintermediation, etc. Studies have shown that it positively contributes to economicdevelopment through financial intermediation in the financial market, particularly the long-term investment market (Brainard 2008). That is attributable to the inherent need of insurancecarriers to “match” longer term obligations with longer term, relatively stable investments. Data shows that through its investment intervention in the market, Takaful provides afairly steady source of liquidity. Put differently, Takaful is a source of funds, i.e.contributions from its members or participants. Those funds quickly find their way into thefinancial market after payment of concomitant expenses, e.g. commissions, overhead andclaims as they become due and payable. Those funds are invested with firms and governmentas a significant source of liquidity. From the Takaful operator’s viewpoint, these investmentsproduce both income (from profits and dividends), capital gains from the sale of thoseinvestments and other cash flows; all of which represent the cash inflows of the Takaful fund.These aggregate funds inflows contribute to the overall well-being of the financial sector ofMalaysia and her economy. The size of these inflows in Malaysia over the past nine (9) years, i.e. from 2003through 2011 can be seen in Table 2. As can be seen from Table 2, Family Takaful netcontributions provide the “lion’s share” of the liquidity at 76.2% of contributions; whileFamily inflows represent 60.9% of the total cash inflows from Takaful undertakings atDecember 31, 2011. Net Family contributions grew 9.2% in 2011. Net contributions are net 27
  28. 28. of any brokerage commissions that might result in double counting. Net contributions are alsonet of contributions paid for retakaful. However, it should be apparent that General Takaful inflows have grown dramaticallyover the 9 year period, i.e. a total of 413% or an average of 45.9% per year. Its contributionshave grown an average of 51.2% per year over the past 9 years. General contributions grew12.4% in 2011. Obviously, both lines experienced slower growth in 2011. However,preliminary numbers being reported for 2012 suggest growth may return to the higher levels. Table 2 (In RM millions) 2003 2004 2005 2006 2007 2008 2009 2010 2011 Net Investment Income: Family 165.3 156.6 192.3 232.0 284.5 298.8 354.8 447.3 501.3 General 21.5 14.7 19.6 32.3 44.6 50.6 57.7 68.4 84.5 Total Net Investment Income 186.8 171.3 211.9 264.3 329.1 349.4 412.5 515.7 585.8 Sale of Assets & Other Income: Family 41.2 77.5 69.5 123.4 111.8 164.9 307.1 336.4 647.5 General 8.9 108.3 68.3 78.5 62.7 92.0 79.2 90.4 156.2 Total Other Income 50.1 185.8 137.8 201.9 174.5 256.9 386.3 426.8 803.7 Net Contributions: Family 762.5 794.4 977.1 1,242.3 1,988.5 2,372.9 2,718.1 3,391.1 3,703.6 General 251.5 328.7 356.6 479.2 576.5 652.2 803.7 1,030.7 1,158.9 Total Net Contributions 1,014.0 1,123.1 1,333.7 1,721.5 2,565.0 3,025.1 3,521.8 4,421.8 4,862.5 General Reserves & Write- 326.0 375.4 558.8 662.3 849.7 1,032.3 1,167.2 1,394.4 1,717.2 Backs Total Cash Inflow: Family 969.0 1,028.5 1,238.9 1,597.7 2,384.8 2,836.6 3,380.0 4,174.8 4,852.4 General 607.9 827.1 1,003.3 1,252.3 1,533.5 1,827.1 2,107.8 2,583.9 3,116.8 Total Cash Inflows 1,576.9 1,855.6 2,242.2 2,850.0 3,918.3 4,663.7 5,487.8 6,758.7 7,969.2 Adapted from BNM 2011 Statistical Reports Table 3 shows the asset holdings of Takaful in Malaysia from 2003 – 2011, alongwith the respective percentage of those holdings. Family Takaful assets comprise 84.8% oftotal Takaful assets in Malaysia. Almost 98% of Takaful’s RM16.9 billion in assets at yearend 2011were invested in the Malaysian Islamic Capital Market, either directly or indirectly.As can be seen from Figure 3, Takaful provides significant financial intermediation to theIslamic Capital Market in Malaysia with 21% of its investment assets in Government IslamicPaper (GII), 73.4% of those assets were in Shari’ah-compliant private debt and equityinstruments and 5.6% of its directly invested assets in other instruments. Although the BNMreports do not disclose the debt or equity breakdown of Takaful fund capital market activity,Ernst &Young 2012 World Takaful Report, sampled Malaysian Takaful operators, indicatedan allocation of 20% equity and 57% Sukuk; with 20% in depository accounts and roughly3% in real estate. Those amounts approximate the amounts in Table 3. The corresponding 28
  29. 29. Malaysian debt/equity Islamic Capital Market investment would then approximate RM5.2billion and RM1.83 billion, respectively. Table 3 RM Millions and % Family General Total % Fixed Asset 0.9 0.0 0.9 0.0% Investment Properties 306.0 26.6 332.6 2.0% Financing 42.3 0.9 43.2 0.3% Govt Islamic Paper (GII) 2,231.1 380.4 2,611.5 15.4% Islamic Private Debt & Equities 7,935.2 1,196.9 9,132.1 53.9% Other Investments 637.3 64.8 702.1 4.1% Foreign Assets 8.6 0.0 8.6 0.1% Investment Accts & Money Market 2,669.0 601.2 3,270.2 19.3% Cash & Bank Balances 143.2 37.3 180.5 1.1% Other Assets 404.6 261.8 666.4 3.9% Total Investment 14,378.2 2,569.9 16,948.1 100.0% Adapted from BNM 2011 Statistical Reports As noted earlier in this paper, Malaysia has 8 Takaful operators. The majority (6) haveaffiliation with banks or international financial firms. The 2 original Takaful funds are theexceptions, i.e. Ikhlas and Takaful Malaysia. All Takaful operators have investment linkedfunds; generally growth, income, fixed or balanced. The actual investment mix for Takafulfunds varies. Review of Takaful financial statements reveal investment mixes approximatingthe breakdown between government Islamic securities, private Islamic debt and equities anddepository accounts discussed herein above. All Takaful and Retakaful operators in Malaysiaare required to have a investment policies that reflect the reasonable expectations of theirparticipants pursuant to BNM “Guidelines on Investment Management for TakafulOperators.” Figure 3 Takaful Investment Asset Allocation In Millions RM 702.1 2,611.5 Govt Islamic Paper (GII) 9,132.1 Islamic Private Debt & Equities Other Investments December 2011 Adapted from BNM 2011 Annual Report It is noteworthy to mention that Government Islamic Paper or GII is a controversialIslamic security. They are trust certificates issued on the basis of bai’ al-inah, a method ofIslamic finance that is controversial, as it involves selling a financial product or other item toa party for cash and buying it back at a higher price over time or immediately (a clear case ofriba absent an exemption). It is rejected by the Maliki and Hanbali mudhahib. It is deemedpermissible in the Shafi’ee madhab only; although it is permissible under the Hanafi madhabif it involves a third party. 29