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 Activities Source: 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. Musharaka Partnership between capital providers. Profit, shared in an agreed percentage (e.g. Joint stock companies)h CAPITAL Mudharabah 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. Wakala 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.
Takaful Operation - A Mutual/Cooperative The whole premium is treated as a Tabarru (unilateral Managem contributions) to the Takaful Mutual pool ent and Policyholder Premium Tabarru Income from investment of premium and provision/ reserves sales expenses, reinsuran ce / retakaful expense and claims payable together with Surplus/(Deficit) contributi The policyholders/owners of the Takaful Mutual hires the on to managers to run the operation and the reserves managers in return receive wages After meeting expenses and claims a surplus or deficit accruing to the policyholders arises
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 Administration, distribution, Underwriting, actuarial & finance Investment of Takaful Funds Shariah Contract Wakala Contract Option 1: Wakala Contract Option 2: Mudharabah Contract Company receives A fixed fee calculated as a percentage of premium or alternatively a fixed amount A fixed percentage of funds under management An agreed percentage of the profits from investments
Wakala Model - Family (Life) Takaful SHAREHOLDE R Contribution from Policyholder/Participants PARTICIPANTS SHAREHOLDER Wakala Fee on Contribution x% a% NAV Savings Fund Fund Management Wakala Fee Periodic Tabarru Commission Mgmt Expense Profit (1-x)% Takaful Risk Fund Fund Mgmt Costs Profit Wakala Fees 100% surplus distributed to Participants Claims
Revenue Account comparison between conventional and takaful Income Expenditure Operator Income Expenditure Premium Investment Income on Capital Technical Reserves Claims Management Expenses Commission Wakala Fees Investment income on capital Takaful Fund Income Management Expenses Commission Expenditure Conventional Insurance Premium Investment Income Takaful Wakala Fees Claims
Balance Sheet comparison between conventional and takaful Total Assets Capital & Retained Earnings Insurance Liabilities Operator s Assets Takaful Assets Capital & Retained Earnings Takaful Liabilities Conventional Insurance 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
Comparison between conventional insurance and takaful The Issues Conventional Insurance Takaful The box black The investment The benefits The uncertainty (gharar) 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. Insurance companies invest in riba earning instruments and in companies involved in forbidden businesses. In some cases the policyholder may over insure 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. 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. No riba investments and investments only made in accepted businesses (significant overlap with Socially Responsible Investments). Strictly a contract of Indemnity. 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.
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