Like any fledgling industry, Takaful has its hands full trying to grapple with the various risks that face this young and alternative form of insurance. GAUTAM DATTA believes however that the most fundamental risk is the issue of sustainability of long-term capital — the ‘capital conundrum’.
Conventional insurance as the mainstream insurance channel is widely perceived as being centuries old (over 300 years if insurance deals done by Lloyd’s of London are assumed to be the beginning of modern day insurance) and has had the advantage of time to reflect and address its risk exposure. In comparison, Takaful is only about 30 years old. Its youth and the complexities of modern financial regulations make risk management in Takaful challenging.
Risk management is defined as a process of identification, assessment and avoidance or mitigation. In the context of Takaful, the focus is on traditional risks faced by an enterprise based along conventional lines. These would apply to the areas of business strategy, underwriting, investment and compliance — regulatory and Shariah, manpower etc.
In most Takaful conferences, these risks tend to be the main subjects of discussion. I believe the industry faces a more fundamental risk — that of sustainability and availability of long-term capital. Ernst & Young in its World Takaful Reports 2011 and 2012 remarked that performance of capital in the GCC Takaful segment has been below par. I fear that this will discourage future investment and will keep multinationals away from participating in Takaful ventures — which is essential to the growth of the industry. We have already seen the withdrawal of Allianz Takaful and the scaling down of AIG Takaful.
The cost of reinventing the wheel by not feeding off the experience of the conventional insurance industry gathered over three centuries will be very high. Let me share my thoughts on where the disconnect is in the current model, along with a possible solution.
The word Takaful originates from the Arabic word ‘Kafala’ which means ‘solidarity’. It is the community spirit of mutual guarantee in the event of any of its members experience financial misfortune. This form was evident in the Code of Hammurabi (1772 BC). The principle is that of risk sharing amongst the policyholders and not of risk transfer as embodied in conventional forms of insurance. Notwithstanding the mutual aspect of Takaful, current regulations require capital to establish a Takaful operation.
The capital providers are known as operators, who in a Wakalah model (which happens to be the most widely adopted structure) manage the policyholders’ funds as an agent for the policyholder. In return for this service, the operator gets a fee that is expected to cover operational cost and reasonable profit. This profit however is not related to return on capital because Shariah does not stipulate requirements for capital. If the conditions are closely scrutinized, it will be seen that Shariah demands that policyholders be responsible for guaranteeing the solvency of the fund.
However, licensing regulations require minimum capital and to comply with the business model, regulation also imposes obligatory Qard Hassan undertaking from the shareholders/operators. This basically means that shareholders actually put up their capital as a guarantee towards any solvency deficit in the policyholders’ fund. In some distorted way, the perfect segregation between shareholders’ and policyholders’ fund gets compromised when shareholders put up their capital by way of guarantee for the policyholders’ fund. Understandably this is done as an interest-free loan but the fact that this is not optional vitiates the spirit of the loan.
Furthermore, the practical reason for implementing this is because in the current market, Takaful companies would find it difficult to attract customers if they were told that they would have to contribute an additional amount towards the fund in the event of a deficit, thus defying the basic concept of risk sharing. Current practice results in policyholders sharing risks only at the time of surplus and shareholders taking on the load in case of deficit. The bias against the shareholder is not rewarded with any incentive.
In recent times, the concept of a performance fee based on the performance of the policyholders’ fund has been debated and AAOIFI has acknowledged it but stipulated that the incentive should be to the credit of the managers and not the shareholders. Poor return on equity is therefore driven by the fundamental mismatch between the concept and practice of Takaful where capital is the critical differentiator.
The cliché “the end justifies the means” in the case of Takaful would mean all the work-around that takes place for the model to comply with the requirements of Shariah. While the basic mutual model would have complied with the requirements of Shariah, it must be recognized that a mutual does not require any capital. The regulators however do and a Takaful business plan usually paints an optimistic picture for the investors to attract them to invest. In almost all cases, the gap between that promise of return and the actual remains insurmountable.
Theoretically, the price of the capital can be built into a Wakalah fee in which case there would be no discrimination against the capital provided by the shareholders. In reality however, the pricing is subject to market conditions and has very little bearing with technical pricing. Even on the conventional side of the business, most technical rates get heavily discounted to arrive at the commercial rate. In the event the performance of the portfolio falls below expectations which leads to a deficit in the policyholders’ fund, it does not impact the P&L of the shareholder as the Wakalah fee is recovered in advance.
On the other hand, the obligation to provide an interest-free loan (Qard Hassan) in case of deficit in the policyholders’ fund makes the return recovered in such a way a debatable one. It is transferring money from one pocket to another even though it may take place through different forms of income statement. The end result is that the policyholders’ fund is obligated to pay off the shareholders’ fund first till the Qard is extinguished.
In most cases, this may range from three to five years and even up to 10 years. In certain territories, regulations stipulate that shareholders must write off the loan after certain number of years. This should enforce impairment provisions on shareholders’ balance sheet which is not in practice at present.
It has been acknowledged that the success of Takaful will depend on its appeal to the masses and not just for the Muslim population. The most attractive feature of Takaful is the sharing of surplus in the policyholders’ fund. However, when this surplus is not forthcoming within a reasonable period of time, participants can soon become disillusioned. This can eventually lead to loss of credibility and the possible demise or marginalization of the Takaful industry.
The solution lies in the principle of regulation. In almost all cases, Takaful law, rules and regulation are variants of the conventional ones. As I have cited earlier in this article, setting up Takaful with work-around solutions actually creates more complexities. The right way would be to treat Takaful as diametrically opposite to the conventional industry. If the conventional requires capital then Takaful should not be subject to it.
However, in order to protect the interest of the policyholder, the shareholders may be called upon to guarantee any deficit in the fund and infuse cash if the fund runs out of cash to operate. The rule may call upon the policyholders’ fund to pay a fee for this guarantee and a profit rate for the capital borrowed to maintain its cash flow.
I believe that Shariah scholars appreciate the complexities of modern day commerce. The imposition of a fee and profit rate may run counter to the original principles but by the same token, a minimum capital requirement is stipulated by modern day regulators and not by Shariah. The capital provided in the early stages to start the operation can be treated as cash borrowed towards working capital by the policyholders’ fund and the same is paid back with an agreed profit rate over an agreed period of time.
Any requirement of capital to maintain solvency margin can be done by way of guarantee for which a fee can be paid for the duration of the guarantee. The rate of guarantee and rate of profit can be based on charges levied by an Islamic bank. These are early thoughts and brainstorming may help in finding a way out of the ‘capital conundrum’ in Takaful.
Gautam Datta is the CEO at Al Madina Gulf Insurance Co. He can be contacted at
[email protected]
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