The role of the Takaful Operator
Issues in Product Management
Source of returns
Takaful (even when organized as a profit-seeking venture) is not the same as conventional insurance. The differences lie in the source of returns. Returns for a conventional insurance company come from two sources. First, the company generates return by investing the insurance premiums (the premium is the conventional name for participant’s contributions in Takaful) and the shareholders’ funds. The second return is sourced from underwriting profit, which is the difference between what the policyholders contribute through premiums and what is paid as insurance claims, benefits and compensation. In all areas, the Takaful Operators must fully comply with the rules of Shariah. In contrast, the conventional insurance company is not required to do so.
In Takaful, any surplus that is a result of overpricing or over-charging is required to be returned back to participants.
In the event of under-pricing, the Takaful participants may be asked to meet any underwriting deficit or negative difference between the policyholders’ contribution and the actual claims, benefits and compensation paid. As a matter of principle, the Takaful Operator has no automatic rights or obligations relating to such surplus or deficit.
A modified mudarabah model that is used by Malaysian Takaful companies, specifically for General Takaful business, involves a departure from the above principle. In this scheme the premiums are determined by urf or custom (market). This means the rate of premium is comparable to that charged by conventional insurance companies. Profit is defined as underwriting surplus plus returns on the investment of the general Participants Takaful Fund, which is then subject to profit sharing between the participants and the Operator under the mudarabah contract. It is a modified version of mudarabah, the distinct feature of this arrangement is that it transforms Takaful entirely into a profit-seeking commercial venture. The Takaful Operator is now the mudarib for managing the entire business of takaful, not just the Participants’ Takaful Fund. As such, the Operator also shares in the underwriting surplus / deficit. The arrangement has now come to be known as the Malaysian modified mudarabah model. Proponents of this model assert that it allows takaful to withstand competition in the market place. Should the original mudarabah model be used, the Takaful Operator would have to charge a higher rate as contribution or premium to the takaful participants to cover its expenses. This would not allow the business of takaful to compete with conventional insurance.
In Islamic insurance, the Takaful Operator acting for the participants has no claim in surplus from the underwriting operations but may share in the income from investment of funds on behalf of the participants. In profit-making entities the investment income shared between the participants and the Takaful Operator must be on the basis and ratios agreed in advance; this is not required in the pure wakalah model where an agreed fee may only be paid for managing both the underwriting operations and managing the investment of the Participants TakafulFund; this is also the case in the pure waqf model where the participants may act as their own manager.
Sharing of Surplus
While Takaful Operators may share in the invest income generated from the participants funds managed by them, the shareholders of the Takaful Operator are not entitled to share in the underwriting surplus of the business. This surplus may only be distributed to the participants by reduction on the amount of their contributions or allocating all of the surplus to special and other suitable reserves or utilising for welfare and charitable causes (without the need for any distribution among the participants).
Level of Surplus/Reserves
In keeping with the takaful basis of solidarity and mutual assistance, it is necessary to use the surplus to first build up contingency reserves to a level sufficient to protect the fund from volatile results and to support further growth. Thereafter, any excess may be distributed among the participants.
Sharing of Expenses
The direct expenses incurred by the Takaful Operators for managing the Participant Takaful Fund, i.e. directly chargeable to the participants and the direct expenses for investment of funds on the basis of mudarabah are borne by the Shareholders Fund. In the pure wakalah-based model, the problem of profit-sharing does not arise as the Takaful Operator is essentially acting as an agent for managing the takaful business for payment of a defined wakalah fee that covers all expenses. By implication, these expenses are covered by the wakalah fee paid to the Takaful Operator, and thus indirectly charged to Participants Takaful Fund.
Establishment of two separate funds
(i) Participant Takaful Fund representing the contributions paid by the participants with the accrued surplus / deficit arising from the underwriting operations – the surplus or deficit from the underwriting operations will accrue to the fund to which the Takaful Operator does not have direct recourse. This separation is to protect the participants’ fund from any deficit that may arise in the Shareholders Fund.
(ii) Shareholders Fund representing the capital subscribed by the shareholders / promoters to develop the business plus the accrued share of the profits from the business; the management expenses is borne by the Takaful Operator either from a predefined agency fee (wakalah) or a share of the income from investing participants funds.
Iranoperates insurance on Islamic basis, but the distinction between the participants and shareholders is not as delineated as above, participants are provided a share of the surplus depending on the overall financial strength of the company. The primary focus is the manner in which all investments are managed on Shari’ah-compliant basis such that the system has no element of riba.
Co-mingling of Funds
A mudarib (Takaful Operator acting on the basis of profit-loss-sharing under a mudarabah contract)) or wakeel (Takaful Operator acting on the basis of agency for a predefined fee) are required to hold the participants fund (Participants Takaful Fund) and the Shareholders Fund separately. However, the Takaful Operator can commingle both funds for investment purposes in which case the distinct identities of the two funds attributable to the participants and to the shareholders must be maintained along with the investment income attributable to each fund. Expenses and overheads relating to joint investment operations are charged to both the funds on a pro rata basis.
Obligation to provide interest-free loan
The involvement of the Takaful Operator as mudarib or wakeel is not merely restricted to managing the Takaful business. In the event of a deficit in the Participants Takaful Fund (defined in general as claims exceeding contributions), the Operator has the additional responsibility of providing qard-hasan (benevolent or interest-free loan) on a voluntary basis to cover any deficit to maintain the solvency of the Participants Takaful Fund and provide adequate security to the participants.
The Takaful Operator must be committed to providing an interest-free loan (qardhasan) to the Participant Takaful Fund. The qard-hasan is repaid out of future surplus.
Restrictions on investments
The Takaful Operator must be guided at all times by the Shari’ah in its investment policy. Any deviation or non-compliance would make the scheme invalid.
Participants as Owners
The participants essentially own a Takaful business which is funded by their contributions. For these reasons, the participants must have adequate representation on the Board of the Takaful Operator and a right scrutinise its transactions and accounts.
Fund Transparency and Financial Reporting
An important issue for the participants is the transparency of management of their own funds (the Participants Takaful Funds) by the Takaful Operator and the extent of the financial reporting on this aspect. An essential feature of all Takaful business models is the requirement of the participants to share the underwriting surplus / deficit arising from the underwriting operations and investment of their contributions. Therefore, the participants should be fully aware of the position of the Participants Takaful Funds and the profitability for viability of the business. Equally, the Takaful Operator must produce its own audited accounts, not only to comply with regularity requirement in all jurisdictions, but also to report primarily to its shareholders, and secondarily to the participants who have an interest in the performance of the Takaful Operator and on the company’s capital adequacy to cover the underwriting operations as well as in the fulfillment of the Shari’ahcompliance requirements.
Reinsurance or Retakaful involves a second arrangement between a Takaful Operator and a larger operator as the former may not have the capacity to absorb allpossible losses out of its own resources, given the large sums that are insured.Retakaful must be undertaken following the same principles as are applicable forTakaful and in compliance with the Shari’ah principles. According to somecontemporary Shari’ah scholars, Takaful Operators may be permitted to reinsurewith conventional reinsurance companies if necessary, on the grounds of “pressingsocial need” when there are no other or insufficient avenues for investment of TheParticipant Takaful Funds in accordance with Shari’ah principles.According to traditional reinsurance practice, the insurance company passes thepremiums it receives from the insured to the reinsurance company for the risksinsured with the reinsurance company and, in return, receives a commission fromthe reinsurer towards its management expenses. The insurance company is alsopaid a profit commission by the reinsurance company as a reward for careful andsound underwriting. Such commission is not considered permissible as this wouldimply that the Takaful Operator is acting as a mere agent of the reinsurer. What ispermitted however, is that the Takaful Operator must deal with the Retakaful insureron a net (risk) premium basis only or may enter into a profit-sharing arrangementwith it.
The Takaful Operator is required to establish a Shari’ah Supervisory Board (SSB) to ensure that all aspects of its Takaful business (products, business operating model, investment policy, profit distribution/sharing agreements, etc.) comply with the Shari’ah principles. Corporate Governance and Regulations are discussed in detail in Lesson 6 of this Module.