This document discusses various legal and regulatory issues related to takaful (Islamic insurance). It covers topics like takaful dispute resolution, regulations in countries like Malaysia, the lack of legislation in most countries, guidelines from Bank Negara Malaysia, different takaful management models (mudharabah, wakalah, hybrid), the role of waqf, contractual clauses, nomination clauses and Islamic succession laws, the qard facility, and challenges with the proprietorship structure of most takaful operators. It emphasizes the need for standardized dispute resolution mechanisms and a unified regulatory framework for the growing global takaful industry.

1. Legal and Regulatory
Issues in Takaful
By: Camille Silla Paldi

2. Takaful
 Takaful is almost the same concept as conventional mutual insurance, except
that the takaful operator can inject an interest free loan called qard hassan
into the fund in the event of insolvency.
 Islamic insurance is based on cooperative risk sharing and joint-guarantee,
which are concepts already widely used in the West and favored by ethical
people, Christians, Muslims, and Jews.
 Takaful can be considered a form of investment insurance with coverage and
is a valuable financial tool for people seeking coverage, investment returns,
diversification of portfolios, wealth management, and retirement plans.
 It is also quite useful and widely used by people of all faiths, nationalities,
and backgrounds in international trade finance.

3. Takaful Dispute Resolution
 Takaful disputes are largely settled in civil and common law courts, similar to
Islamic finance transactions.
 This may be problematic due to the non-application and misapplication of
Shari’ah and the lack of understanding of Islamic finance and Islamic
insurance in civil and common law courts.

4. Malaysia
 Parallel Shari’ah and Civil Court System.
 Since Bank Islam Malaysia Berhad v Adnan bin Omar and Dato Nik Mahmud bin
Daud v Bank Islam Malaysia Berhad, banking matters fall under mercantile
laws, which according to the Federal Constitution, shall be under the Civil
Court’s Jurisdiction.
 If an Islamic finance of Shari’ah issue arises, the civil court can then refer the
matter to the National Shari’ah Advisory Council at Bank Negara Malaysia for a
ruling.

5. Countries with Specific Takaful
Legislation
 Malaysia
 Brunei
 Pakistan
 If only three countries possess Takaful legislation, the global Takaful industry
is heavily under-regulated as well as lacks as proper dispute resolution
mechanism.

6. Bank Negara Malaysia Guidelines
 Guidelines on Operating Costs of Family Takaful Business;
 Guidelines on Claims Settlement Practices;
 Guidelines on Directorship for Takaful Operators;
 Guidelines on Prohibitions against Unfair Practices in Takaful Business;
 Takaful (Prescribed Financial Institution) Loan and Investments Regulation
2003;
 Guidelines on Financial Statement for Takaful Operators;
 Takaful Operators Statistical System.

7. Takaful
 A unique and harmonized regulatory and reporting regime is required for
takaful for many reasons including the two-tier structure of takaful
companies, which includes shareholder and policyholder funds.
 Shareholder and policyholder funds are managed separately and capital may
not be fungible or transferable between the two separate accounts.
 Furthermore, takaful funds have unique policyholder entitlements and rights,
different structures, and face different risks compared to conventional
insurance.

8. Takaful
 The main difference between conventional and Islamic insurers lies in the
fact that in Islamic finance, the assets underlying the underwriting pools are
owned by the policyholders, whereas assets in conventional proprietary
insurance companies are owned by the shareholders and must at all times be
sufficient to cover their obligations to the policyholders.
 Accordingly, in contrast to conventional insurance companies, takaful
companies must make disclosures about the underwriting pools and
underlying assets.

9. Takaful
 The AAOIFI regulations FAS 12 General Presentation and Disclosure in the
Financial Statements of Islamic Insurance Companies and FAS 13 Disclosure of
Bases for Determining and Allocating Surplus or Deficit in Islamic Insurance
Companies address many of these issues.
 The AAOIFI standards require disclosures on policyholders’ funds and the
determination and allocation of surplus and financing of deficits.
 However, the requirements in respect of movements between the funds
should be enhanced and the individual rights of the policyholders should be
clearly stated in the financial statements.

10. Takaful
 There is also a lack of transparency in the financial statements of some
takaful companies in regards to undistributed fund balances.
 Overall, the current financial reporting practices of takaful companies do not
provide adequate information regarding the company’s investment strategy,
funds allocation, and revenues and expenses accruing to their particular
investment funds.
 Exacerbating the situation, takaful companies have not yet adopted a single
framework for financial reporting and this has resulted in the lack of
transparency and comparability of financial statements.

11. Takaful
 In terms of capital adequacy regulation, it may be difficult to apply ratio-
based methods as it can be difficult to accommodate them to the different
structures adopted by takaful operations and their different risk profiles.
 For this and other reasons, it is more advantageous to develop risk-based
capital regulation (RBC) for the takaful industry.
 In the RBC, calculating the capital requirement is combined with evaluating
management practices and internal controls. In this process, there is a major
role for the regulator in reviewing and evaluating the process by which the
calculated capital requirement was arrived at and imposing additional capital
add-ons if the regulator is not satisfied with the insurer’s risk management.

12. Takaful
 In this process, there is a major role for the regulator in reviewing and
evaluating the process by which the calculated capital requirement was
arrived at and imposing additional capital add-ons if the regulator is not
satisfied with the insurer’s risk management.
 The insurer determines its minimum capital requirements by applying risk
factors to each of the identified risk components, reducing the resultant
amounts by identified risk mitigants, and aggregating the results.
 Some further reductions may be possible by identifying diversification effects,
though on the other hand the regulator may impose add-ons.

13. Takaful
 Takaful operators may be comparatively overweight in assets such as equities
and real estate, which tend to be more volatile and/or less liquid, thereby
attracting higher risk weightings.
 In many jurisdictions, solvency and capital requirements for takaful
companies remain simple, however, several countries including Malaysia,
Indonesia, and certain GCC countries are moving towards risk-based capital
regulation.

14. Takaful
 Takaful is faced with various other challenges including scarcity of suitable
Shariáh compliant investments and very few retakaful or reinsurance
operators in the world today.
 These shortages can lead to concentration risks or lower-quality assets than
desired by the takaful business.
 Furthermore, there is a limited availability of risk management tools for
takaful similar to Islamic finance and more attention needs to be paid to
product design, IT, and control processes.

15. Takaful
 Takaful investment management requires further development in Islamic
financial theory and practice.
 Develop Shari’ah compliant risk management techniques.

16. Shari’ah Boards
 Takaful operators generally have their own Shari’ah Boards to ensure
compliance with Shari’ah.
 Very few jurisdictions have a central Shari’ah Board.
 This may benefit the industry by ensuing a unified opinion throughout the
jurisdiction on Shari’ah issues relevant to the industry and to provide a solid
legal backing to a fatwa so that Shari’ah compliance will be effective and
enforceable in the courts.

17. Shari’ah Boards
 The lack of legal backing for the establishment of Shari’ah Boards, as well as
adequate regulatory rules may continue to raise doubts regarding the
effectiveness and enforceability of the contracts employed by takaful
operators.

18. Investment Activities of Takaful
Operators
 Takaful operators are both insurers and fund managers and the Takaful
regulations and legislation should reflect this.
 This also requires the appropriate legal, financial, and administrative
firewalls.
 Takaful operators require a unique governance structure that facilitates (i)
the consistent screening of the investment portfolios in order to ensure they
remain Shari’ah compliant; and (ii) the purification of any return on the
investment from non-Shari’ah compliant income. (Takaful legislation exists
only in Pakistan, Brunei, and Malaysia) This governance structure requires
legislation as a basis for the corporate structure and regulation.

19. Investment Activities of Takaful
Operators
 The financial regulatory authority might be interested to know how the
takaful operators dispose of their non-Shari’ah-compliant income, particularly
vis-à-vis related-party transactions that may involve conflicts of interest.
 It may be useful to supervise the investment activities of the takaful
operators borrowing some of the principles used by securities regulators.

20. Takaful Management Models
 The contract between the participants and the licensed Takaful operator
could be based on Wakalah or Mudarabah or a hybrid of the two.
 This contract refers to a management contract between the participants and
the Takaful operator.

21. Takaful Management Models
 Mudharabah
 Wakalah
 Hybrid Wakalah-Waqf Model

22. Waqf
 Instead of using the principles of mudarabah or wakalah, takaful schemes
should adopt the principle of waqf, which would make it clearer that a
takaful undertaking is strictly non-commercial and based on the principle of
mutual assistance.
 In common law countries such as the UK, Pakistan, and Malaysia, a waqf
would likely be governed under the Trust Law of the country.
 However, a key question is whether in a waqf-based takaful model, whether
the parties can contract out of the statute by creating sets of roles and
responsibilities for the trustee under the waqf deed, which are different from
those already specified in the Trust Act.

23. Waqf
 A takaful operator may also need to register each takaful fund as a waqf in
order to enjoy tax benefits normally granted to a waqf as a charitable entity;
otherwise, a different tax treatment may be applied to those waqf.

24. Qard Facility
The takaful operator grants a qard or interest free loan in the event of a deficit
in the takaful fund (in contrast to mutual insurance).
The takaful operator is expected to offer a qard loan facility, which can be drawn
down if the fund is unable to meet its obligations (because of a deficit or lack of
liquidity).
The loan does not remove a deficit, as it increases the fund’s liabilities
simultaneously with the assets, but it provides liquidity to enable the fund’s
obligations to be met.

25. Qard Facility
 The loan should be recoverable by the takaful operator through future
underwriting surpluses.
 Considering that the takaful fund is under the direct management of the
takaful operator, such a loan may fall under the broader context of ‘related
party.’
 Related party transactions must be publicly disclosed and only carried out on
an arm’s-length basis without any unduly favorable terms.
 In some jurisdictions, independent valuations and appraisals are required
before the regulatory authorities will allow substantial related-party
transactions to take place.

26. Qard Facility
 This is in order to avoid the directors and management of the company
manipulating the movement of funds or assets of the company in favor of
certain parties who are related to or favored by them.

27. Qard Facility
 Should the requirement to publicly disclose the qard facility be similarly
imposed on takaful operators on the basis that it is a related-party
transaction?
 Should the existence of the facility be disclosed or only the loan if the facility
is actually drawn down?
 While it would seem desirable to disclose the existence and amount of the
facility, transparency would also require disclosure of the draw-down amount
when made.
 Certain safeguards may also be required in order to ensure that the qard is
not employed in a manner that favors certain pools among the many pools of
takaful funds under the management of a takaful operator.

28. Qard Facility
 In countries such as Malaysia, takaful operators are obliged to give an
undertaking to the regulator to provide a qard facility to be drawn down in
the event of a deficit of a takaful fund.

29. Contractual Clauses
 Takaful, like conventional insurance, is based on the principles of insurable
interest, indemnity, subrogation, and utmost good faith.
 Insurable interest ensures that a client can obtain insurance only if
susceptible to loss for which insurance is sought.
 Indemnity implies that a claim can be made only to the extent of the actual
financial loss to be insured.
 Subrogation entitles insurers to claim from a third party on behalf of the
insured.
 Indemnity and subrogation together ensure compliance with the requirements
of insurable interest.

30. Contractual Clauses
 The utmost good faith clause is required for the disclosure of all material
facts.
 Takaful participants should be protected by the financial regulatory authority
and contractual clauses should be standardized.
 In addition, some takaful participants may make dishonest claims and thus,
adequate legal protection should be given to the other participants.

31. Takaful Operator as Agent
 Disputes and ambiguities may result from the almost absolute discretion of
the takaful operator to act as agent for the takaful participants in the
management of the takaful fund investments and the utilization or
distribution of underwriting surplus and any misconduct or negligence on the
part of the takaful operators.

32. Takaful Operator as Agent
 Often, takaful operators hire other agents to market takaful products and to
deal with the participants on behalf of the operator.
 These additional layers of principals and agents add complications,
particularly in relation to the fiduciary duties of takaful operators, the
conduct of the agents/brokers, and how takaful participants seek remedies
for any loss attributable to misconduct and negligence of the takaful
operators.

33. Effect of Nomination Clause on Islamic
Succession Laws
 A nomination clause in an insurance policy may allow a Muslim to violate the
rules of wills and inheritance as a person nominated may be an heir and/or
may end up getting more than one-third of the assured’s estate.
 This is so because a nomination is made by the assured during his lifetime but
takes effect on his death.
 On the other hand, some scholars argue that a takaful benefit should not be
considered as part of the deceased’s estate, because it does not form part of
the deceased’s assets during his lifetime.
 In fact, the takaful benefit comes from a pool of funds derived from
donations of other takaful participants as well, in part even after the
deceased has died.

34. Effect of Nomination Clause on Islamic
Succession Laws
 In Pakistan, in the case of Karim v Hanifa, it was held by the Karachi High
Court that the status of the nominee in life insurance is nothing more than an
agent (or executor) who receive the benefit on behalf of all the heirs.
 In Malaysia, the NSAC resolved in 2003 that whether a nomination clause in a
takaful contract results in the takaful benefit being a hibah (gift) or part of
the deceased’s estate, which is subject to inheritance, depends on how the
clause is constructed.

35. Proprietorship
 Most takaful operators are licensed as proprietorships and not mutuals.
 However, in reality, they are mutual operating within the set-up of a
proprietorship body corporate.
 Here, what is supposedly a mutual, that is, the takaful participants coming
together to make contributions (replacing the premiums in conventional
insurance) and thus, rightfully owning whatever is in the takaful fund,
including any assets and liabilities – is actually operated and managed, almost
with absolute discretion, by a proprietorship corporation – that is, a takaful
operator – acting as the managing agent on behalf of the takaful participants.

36. Proprietorship
 It cannot be treated as a mutual when the law of the country does not
accommodate the setting up of such forms of company with no shareholders.
 Moreover, the regulators issue the takaful license specifically to the takaful
operator on the basis of its form as a proprietorship with properly identified
share capital and shareholders.
 Thus, as far as the regulators are concerned, the takaful scheme is not a
mutual.
 It is not purely a proprietorship either, as we cannot erase the actual
ownership of the takaful fund in which the takaful participants pool their
money – these funds are certainly not the shareholders.

37. Proprietorship
 In other words, to treat the takaful scheme as a pure proprietorship would
jeapordize the whole takaful concept and contracts.

39. THE END