Takaful : defining “ethical”

insurance

Zainal Abidin Mohd. Kassim

Partner

Mercer

Presentation contents

• Takaful – a primer

• Shariah Laws governing trade and business

• Takaful in practice

• Shariah compliant investments

– Equities

– Sukuks (Bonds)

• Ethical Insurance defined

Takaful – a primer

• A takaful company is equivalent to a

Mutual/Cooperative insurance company

• Fundamental principles are

– Sharing of risks rather than transfer of risks to a „third

party‟ (i.e. transfer risk to capital

providers/shareholders for a premium). Takaful

embraces the concept of Mutuality.

– Participants (policyholders) do not expect to gain

financially in the arrangement (strictly a contract of

indemnity).

Takaful – a primer (contd.)

– „Price‟ of coverage i.e. premium, is ultimately

dependent on the mutual fund‟s experience through a

process of profit and loss sharing. It is not fixed as in

proprietary insurance.

Takaful – a primer (contd.)

• Shariah Advisory Board (SAB) represent another

level of governance in Takaful

• Need for SAB members (specifically individuals

learned in Islamic business jurisprudence) to

“sign off” on operation. This covers:

– how premiums are treated contractually (when it is

“donated” and when it is invested)

– what investments are allowed

Takaful – a primer (contd.)

• SAB members are not concerned about the

business aspects of the operation other than;

– A need for the business to maintain the highest level

of transparency in all transactions

– Ensure good business ethics are upheld

Shariah – Balance between

idealism and practicality

• Islam sees itself as offering its believers a

practical way of life

• Sharia extends two sets of rules

– One is based on the ideal objectives of Sharia,

keeping strictly to the Islamic law as presented from

an interpretation of the Quran and the Sunnah. This

would be seen as the true Islamic order.

– The second is based on concessions necessary as a

result of extenuating circumstances. This would result

in a temporary relaxation of true Islamic Law.

Shariah – Balance between

idealism and practicality

• Application of these exemptions is determined

by the Sharia scholars and can result in

seriously conflicting fatwas between different

Sharia scholars.

How Islam affects the Muslims

Way of Life

ISLAM

AQIDAH

(Faith & Belief)

SHARIAH

(Practices &

Activities)

AKHLAQ

(Morality & Ethics)

Ibadah

(Worship)

Muamalah

(conduct of

Transactions)

Ahwal Syakhsiyyah

(Family Matters)

Jinayat

(Crime and

Punishment)

Economic Activities

Banking & Financial

ActivitiesSource: Islamic Banking and Finance Institute Malaysia

Conditions underlying a Shariah

compliant contract of compensation

• No Riba (interest, usury)

• No Gharar (uncertainty, sale of risk)

• No Maysir (gambling)

• Engage in permissible (halal) dealings and avoid

prohibitive (haram) dealings. Effectively a subset

of Socially Responsible Investment.

Shariah compliant contracts of

compensation (sample)• Commercial contracts are defined by contract types.

Each contract type automatically assigns specific rights

to the parties to the contract.Partnership between capital providers.

Profit, shared in an agreed percentage

(e.g. Joint stock companies)h

Partnership between capital provider and

entrepreneur. The former brings capital,

the latter brings expertise/effort. Profit is

shared in pre agreed percentages.

Losses accrue to capital provider only.

Entrepreneur bears his own expenses.

Entrepreneur given a fixed fee for his

expertise/effort. Does not share in profit or

loss which accrues to the capital provider.

Entrepreneur bears his own expenses.

Musharaka

Mudharabah

Wakala

CAPITAL

Takaful Operation

- A Mutual/Cooperative

• The policyholders/owners of the Takaful Mutual hires the managers to run the operation and the managers in return receive wages

• After meeting expenses and claims a surplus or deficit accruing to the policyholders arises

Income

from

investment of

premium

and

provision/

reserves

Premium

TabarruPolicyholder

• The whole premium is treated as a Tabarru‟ (unilateral

contributions) to the Takaful Mutual pool

Surplus/(Deficit)

Managem

ent and

sales

expenses,

reinsuran

ce /

retakaful

expense

and

claims

payable

together

with

contributi

on to

reserves

Takaful Operation – Hybrid

(Proprietary/Mutual alternative)

• The policyholders could alternatively “contract out”

certain of these functions to a proprietary company (the

Takaful Operator, TO). Under this hybrid approach these

functions are performed on behalf of the policyholders

through appropriate Shariah compliant contracts.

• Under this approach, and for example using the Wakala

(Agency) contract, the premium is first divided between

the fee payable to the Company (which is paid into the

shareholders account), the Tabbaru’ (which is paid into

the Takaful risk pool) and any savings portion which is

accounted in a policyholders personal account.

Takaful Operation- Hybrid

(Proprietary / Mutual alternative)

Takaful Pool

outsources

Shariah

Contract

Company receives

Administration, distribution,

Underwriting, actuarial &

finance

Wakala Contract A fixed fee calculated as a

percentage of premium or

alternatively a fixed

amount

Investment of Takaful

Funds

Option 1:

Wakala Contract

A fixed percentage of

funds under management

Option 2:

Mudharabah

Contract

An agreed percentage of

the profits from

investments

Wakala Model

- Family (Life) TakafulContribution from

Policyholder/Participants

x%

(1-x)% Takaful Risk

Fund

Periodic Tabarru‟

Wakala Fee on

Contribution

Commission

SHAREHOLDE

RSHAREHOLDER

Fund

Management

Wakala Fee

Mgmt

Expense

Profit

100% surplus

distributed to

ParticipantsClaims

Profit

Fund Mgmt

Costs

PARTICIPANTS

Wakala Fees

Savings

Fund

a% NAV

Conventional

Insurance Takaful

Income

• Premium

• Investment

Income on

Capital

• Technical

Reserves

Expenditure

• Claims

• Management

Expenses

• Commission

Income

• Wakala Fees

• Investment

income on

capital

Expenditure

• Management

Expenses

• Commission

Expenditure

• Wakala Fees

• Claims

Income

• Premium

• Investment

Income

Operator

Takaful Fund

Revenue Account – comparison

between conventional and takaful

Conventional

Insurance Takaful

Total

Assets

Capital &

Retained

Earnings

Operator’s

Assets

Insurance

Liabilities

Takaful

Assets

Capital &

Retained

Earnings

Takaful

Liabilities

Balance Sheet – comparison

between conventional and takaful

What happens to the Shareholders

Fund in case of an underwriting deficit?

• Conventional Insurance

– Net Assets are reduced by underwriting losses

• Takaful

– No effect on Net Assets. Shareholder assets would

however, now include as an asset an interest free

loan owing (Qard Hasan) from the Takaful Fund. This

loan amount would be equal to the cumulative

underwriting losses.

Risks undertaken by the TO

and Takaful Fund

• The Takaful Operator‟s risks are;

– Inadequate wakala fee (expense overruns)

– Inappropriate Investment Strategy

– Non recovery of Qard‟ Hasan

• The Takaful Risk Fund‟s risks are;

– Inadequate contribution (i.e. premium) to pay claims,

maintain claims provision and pay wakala fees

– Inappropriate Investment Strategy

– Inappropriate Retakaful

The Issues Conventional Insurance Takaful

The “black

box”

The policyholder does not know how

his premium is utilised, i,e, how much

goes for expenses , how much goes to

profit of the insurer and how much to

pay claims.

In accordance to the requirement to

avoid Gharar, the Takaful contract

clearly sets out what is for expenses

and profit and what is used to pay

claims.

The

investment

Insurance companies invest in riba

earning instruments and in companies

involved in “forbidden” businesses.

No riba investments and

investments only made in accepted

businesses (significant overlap with

Socially Responsible Investments).

The benefitsIn some cases the policyholder may

over insure Strictly a contract of Indemnity.

The

uncertainty

(gharar)

The policyholder may or may not claim

under an insurance contract. Pure risk

on the part of the policyholder

becomes speculative risk on the part

of the insurance company. Thus, the

insurance contract is not valid in

Shariah law.

The participant may or may not

claim under a Takaful contract. Risk

contributions are treated as

donations and risks are shared

rather than transferred while excess

premiums (surplus) can be

refunded.

Comparison between conventional

insurance and takaful

Equity Return Analysis

Sector Allocation

Sukuks – A primer

• Asset Based not Asset Backed bonds

• Lender (rather than the borrower as is in asset

backed bonds) owns the assets until bonds are

redeemed

• Borrower pays rent (the level of which may be

linked to an index) on the underlying assets until

the loan is repaid

• No capital default, only rental default

Ethical Insurance

• If you take away the misconception that risk

transfer provides a better mechanism to manage

risk, the Mutual model is fairer to the

policyholders than the proprietary life/casualty

office model. Risk pricing is asymmetrical in

nature.

• Capital is expensive, are policyholders really

getting value for the premium they pay over the

“cost of claims”?

Ethical Insurance

• Pensions funds and insurance funds globally

contributes significantly to long term investible

funds

– Should not their investment strategy be driven by

Socially Responsible Investments? Excess returns

can be fleeting in nature and can be at the expense of

the long term quality of life.

– Should these funds support non productive

investments (for example derivatives, financing loans

and lending scripts used to speculate in the financial

markets, etc)

Contact Details

Zainal Abidin Mohd. Kassim, FIA

Mercer Zainal Consulting Sdn. Bhd.

Suite 17.02 Kenanga International

Jalan Sultan Ismail

50250 Kuala Lumpur

Tel:+603 21610433

zainal.kassim@mercer.com

www.mercer.com

mailto:zainal.kassim@mercer.commailto:zainal.kassim@mercer.com