The role of the Re-Takaful Operator and Shariah Principles
Re-Takaful or Islamic reinsurance is essentially about handling risk of Takaful business. It is a risk aversion method in which the Takaful ceding company resorts toeither a conventional reinsurer or a Re-Takaful operator to reinsure original insuredrisks against an undesirable future situation if the risks insured were above thenormal underwriting or claim. Thus, a Takaful ceding company may, based on limitedfinancial resources, hedge against possible incapability to meet all Takaful indemnities if a number of damages occur simultaneously. Hence, it has to seekreinsurance protection from a financially capable reinsurer, which will take over thecoverage of the large proportion of the risk.
The sums insured in modern times have become so large that not even the largest insurance company may be able to singly meet from its own resources all possible losses for all liabilities against insured risks and has to spread its total liabilities among other insurance companies which are the reinsurance companies. Thus there is one contract between the insured and the insurance company and another between the insurance company and the reinsurance company. The reinsurance, for Islamic companies, must be contracted under the same principles as the original contract, that is, in conformity with the Shari’ah, and the reinsurance companies must, of course, be reliable, reputable and financially viable. Islamic companies, however, are expected not to reinsure excessively and needlessly and to give priority to Islamic reinsurance companies when placing their surplus liabilities, making maximum use of their facilities.
Re-Takaful Operators need to ensure that they are capitalized sufficiently to enable them to:
1. Protect the financial stability of Takaful companies from adverse underwriting results
2. Stabilize claims ratios from one year to the next
3. Minimize claims accumulation from losses within and between different classes
4. Geographically spread risk
5. Increase capacity
6. Increase the profitability of insurers through permitting greater flexibility in the size and type of risks accepted
7. Secure technical support and help
Adherence to Shari’ah Principles
As in the case of Takaful business, the Re-Takaful Operator must also strictly adhere to principles of co-operation, protection and mutual responsibility and will avoid acts of interest (riba), gambling (maysir) and absolute uncertainty (gharar). The two main principles are the prohibition of Riba and Gharar which refers to the selling of items having an uncertain existence or uncertain characteristics making the transaction risky and similar to gambling. It is therefore important to distinguish insurance from gambling. All operations and contracts are set-up to ensure that any element of speculation, uncertainty and gambling is eliminated or minimized from them. It is imperative that the Re-Takaful Operator conducts all its affairs in a manner that complies with the Shariah principles whether it is to do with investing its funds, in carrying out its business in all classes of insurance or in any other related financial activity. In the event that the capacity provided by a Shariah-complaint Re-Takaful Operator is not sufficient to support the business strategy of a Takaful Operator, the Takaful Operator, under advice of its Shariah Supervisory Board, may enter into re-Takaful and reinsurance contracts with conventional reinsurance companies till such time that proper re-Takaful arrangements are available.
In re-Takaful (also termed as Takaful reinsurance) for risk sharing pricing purposes, non-proportional arrangements such as excess of loss or stop-loss arrangements may not be suitable because there exists uncertainty with respect to the assessment of losses in those arrangements, whereas Islamic principles demand for clearly defined joint responsibility throughout the coverage period. Hence, Takafulreinsurance is likely to be arranged on a pro-rata basis, e.g., quota share or surplus reinsurance, where the reinsurer becomes technically a co-insurer of the original risks. If, however, a non-proportional reinsurance arrangement is selected, it could be based on a strict profit commission plan or on a reciprocal basis. In this regard, it matters little whether the reinsurance transfer is on a quota or treaty basis.
Re-Takaful: Objective of Reinsurance of Takaful
Re-Takaful is “to enhance Takaful activity by distributing risk. It is mainly for covering large risks and large accumulation of risks subject to common loss”. It is to ensure that Takaful funds are managed to meet indemnity obligations of the insured and reinsured and to assure the continuity of Takaful operations. This means Re-Takafulgives the underwriting capacity to the Takaful Operator. Thus, the objectives of re-Takaful can be summarized in the following:
(1) Protecting the Takaful Operator from the threat of insolvency, underwriting the interest of the participants, forging co-operation among the participants and investing the accumulated fund in an Islamic way;
(2) Providing underwriting flexibility and further consolidating the financial stability of the Takaful Operator in order to compete with conventional insurance companies in accepting risk. This means that re-Takaful “builds a very close continuing business interest in common between the Takaful Operator and the reinsurer because they are both at risk”.
(3) It may allow the Takaful Operator to utilize the retained deposit reserves of the Re-Takaful fund in the interest of its clients without paying interest as a process of making the reinsurance industry an interest free business.
Shariah limitations on reinsurance cooperation with a Conventional Reinsurance Company on the basis of need
To the extent that there are not enough re-Takaful companies capitalized to the levels required by insurers and more particularly the lack of “A” rated Re-Takaful Operators, Takaful Operators are having to reinsure on a conventional basis, contrary to the preferred option of seeking cover on Shariah principles.
The Shariah scholars have allowed Takaful Operators to reinsure on conventional basis so long as there are no re-Takaful alternatives available. Takaful Operators therefore actively promote co-insurance. A number of large conventional reinsurance companies in Muslim countries take on retrocession (Retrocession: A reinsurance of reinsurance or the purchase of reinsurance by a reinsurance company. Example: Company B has accepted reinsurance from Company A, and then obtains for itself, on such business assumed, reinsurance from Company C. This secondary reinsurance is called a Retrocession). For this reason, a large proportion of risk could be placed with international reinsurance companies that operate on conventional basis. To conduct reinsurance co-operation with conventional reinsurers in a manner compatible with Shariah, certain conditions must be fulfilled. These conditions may be categorized into two; namely, general and specific conditions.
(1) The reinsurance co-operation of Takaful Operators with conventional reinsurers should not cause financial injury to Muslims or destabilize the financial systems of Muslim countries. If it does so, the co-operation becomes unlawful for its failure to serve the purpose for which it was permitted: the protection of the financial wellbeing of the Takaful Operators and the participants;
(2) The Takaful Operators must prevent capital flow from the Takaful fund to conventional reinsurance firms. In other words, the reinsurance agreement should be designed in favor of Takaful operations. Moreover, preference shall be given to Re-Takaful (reinsurance) Operators in the matter of securing reinsurance protection whenever possible;
(3) The reinsurance experts of the Takaful Operator should carefully determine the quantum of liability to be reinsured;
(4) The Takaful Operator should reinsure on a net premium basis and not receive any reinsurance remunerations or profit commissions or interest on premiums it has retained from premiums payable to its reinsurer;
(5) The Takaful Operator should review its reinsurance requirement annually and should progressively reduce dependence on conventional reinsurers;
(6) The Takaful Operator must stipulate a condition exempting it from payment of or receiving interest from the conventional reinsurance company. However, if the reinsurance company cannot adjust its management and investment methods to comply with this requirement, the Takaful Operator may accept the interest and spend it on humanitarian activities and public infrastructure projects;
(7) It is incumbent upon Takaful Operators to appoint a Shariah Supervisory Board (SSB) to monitor their operations according to the Shariah principles.
The need for reinsurance protection should be unavoidable. For co-operation with conventional insurers to be justifiable, the need for such cooperation must be unavoidable. Unavoidability here means that reinsurance protection is so crucial that if it is not practiced the society may suffer a considerable financial and social crisis. In this situation, such a reinsurance agreement is permissible because it serves the objectives of the Shariah which includes the protection of life and property.
Dealings with conventional reinsurance companies are justified on the basis of darura when such dealings are badly needed by the public or certain business groups whose businesses have the potential to bring prosperity to society. It is necessary thus to evaluate the co-operation with conventional reinsurance companies in the context of the damage that society might suffer. The law of need or darura alone is not a sufficient legal norm for the legality of any financial transaction.
It has to be supported by the customary practice of society and the magnitude of the need for such a transaction. The need for reinsurance protection must be material and substantial: In the application of darura as a legal norm, the question as to whether there is another alternative lawful means of reinsurance should be carefully evaluated. In other words, any transaction the legality of which is based on compelling need is deemed as having exhausted all lawful avenues of investment and financial transactions. Thus, if there is another alternative lawful means of doing such business, the application of darura is unjustified. However, in the context of the above limitations of necessity/need, seeking reinsurance protection from conventional reinsurance firms is legally valid. The uncertainty or gharar under the above-stated conditions is tolerated for reasons of compelling need.
The concept of reinsurance or reinsurance protection involves essentially two parties:
(1) The insured (the ceding insurance company), that is, the direct insurer which desires to protect itself of part of the risks insured; and
(2) The insurer, the reinsurance company which accepts that portion of the risk, which is to be reinsured by the ceding insurance company.
The term in Islamic finance for these parties is Takaful Operator and Re-Takaful Operator respectively.According to traditional reinsurance practice, the insurance company passes the premiums it receives from the insured to the reinsurance company and, in return,receives a commission from the reinsurer towards its management expenses. Theinsurance company is also paid a profit commission as a reward for careful andsound underwriting.
The insurance premium must be enough to cover the following items:
a) Insured claims
b) Management expenses of the insurance company
c) Provisions for contingencies and profits
It should be noted that the management expenses are born by the participants and not the reinsurer. Strictly speaking, reinsurance of Takaful (re-Takaful) should ideally be with Islamic reinsurance companies or Re-Takaful Operators although Shariahscholars have ruled that Takaful Operators may apply the law of necessity as defined by the Shariah if they require reinsuring with conventional reinsurance companies. One of the boundaries of this ruling is that the transaction should be unavoidable and has been very carefully evaluated. To protect the interests of its participants and shareholders, a Takaful Operator may secure adequate reinsurance protection, subject to the rules on reinsurance commissions mentioned below and following further conditions and limitations as listed below:
a. The premium paid for securing reinsurance protection shall be as low as possible.
b. The reinsurance expert of the company should carefully determine the quantum of liability to be reinsured.
c. Preference shall be given to Takaful and Re-Takaful Operators in the matter of securing reinsurance protection.
d. The Takaful Operator may enter into profit-sharing arrangements with its conventional reinsurers.
e. At the end of each year, the Takaful Operator shall carefully review its reinsurance requirements and should progressively reduce its dependence upon reinsurance.
f. The ultimate goal of the Takaful Operator shall be to put an end to its relations with the conventional reinsurance companies whenever adequate reserves, or enough Islamic insurance and reinsurance companies, are established.
One of the conditions of dealing with non-Islamic companies is that the Takaful Operator must not receive commission from conventional reinsurance company. Todo so would imply that the reinsurer was bearing the insurer’s expenses and that thelatter was a mere agent of the conventional reinsurer. Instead, the Takaful Operatormust deal with the reinsurer on a net (risk) premium basis only or may enter into aprofit-sharing arrangement with them.
Where reinsurance is concerned, the Islamic companies are not forbidden to reinsure on the basis of gross or net premiums, or to receive reinsurance commissions; the parties are free to make their own arrangements. However, in order to bring out the true distinction between takaful and conventional reinsurance systems, it is desirable and preferable for Islamic insurance and reinsurance companies to accept and cede reinsurance business on net premiums. They should not pay or receive any reinsurance commissions other than profit commissions under profit-sharing arrangements.
Reinsurance Deposit Reserve
To minimize financial flows from a conventional reinsurer to a Takaful Operator to claims only, a Takaful Operator may, in line with established reinsurance practice and with prior agreement of its reinsurers, retain a part of the premium payable to its reinsurers as a premium reserve deposit, which shall be dealt with as follows:
a. The premium reserve fund may be considered as free loan and the reinsurer shall not receive any share in investment profits of such reserves. The TakafulOperator retaining the reserves shall alone be responsible for investment losses, if any.
b. The reserve funds may be invested on the basis of mudarabah in consultation with the insuring company and, in this case, the insurance company shall not bear any investment toss unless it is found to be due to faulty decisions or lack of care by the company. The reinsurer shall be paid an agreed percentage of profits net of taxes, and the balance should be retained by the Takaful Operator and may be used for its administrative expenses.