Risk management is the process whereby organizations methodically identify and address the uncertainties attached to their activities with the goal of optimizing the risk/reward relationship within each activity and process, and across the portfolio of activities in aggregate. MOHAMMED HASAN KHAN looks at how this applies to the Takaful industry.
Takaful operations are exposed to many different kinds of risks of both an operational and non-operational nature. They may involve such things as the risk of direct financial loss, of poor customer service, of adverse media comment, of regulatory censure or fine, of legal action, or risks which impact the ability of the takaful operations to actually function and pursue/achieve its annual operating plan and strategic objectives.
Risk management is not about elimination of risk; rather, it is about being aware of the risks to which the operation is exposed and to consciously assess whether each risk as it stands is acceptable or not. Risk management helps ensure resources are allocated to grow the business where the balance of risk and reward is most attractive, thus helping to achieve the company’s strategy.
The risk management process adds a systematic and rigorous approach to what people do already rather than a new layer of bureaucracy. Risk management is a tool to help staff make decisions. It is a means to an end, not an end in itself.
Risk management under Shariah
The Quran says: “…Verily never will Allah change the condition of a people until they change it themselves (with their own souls)…” (Quran 3:11). However, it is true that only Allah knows one’s future and fate, Muslims should strive to achieve the goodness in this world and the hereafter. Submission to Allah, of course, has a positive effect on human behavior. For it will lead to peace and contentment. Undoubtedly, one has to submit every single thing to Allah, but it supposes to be after his hands stretch out to do the best effort as he can, to change himself, so that he would be able to manage and to cope with unforeseen calamities or misfortune.
The Prophet Muhammad (peace be upon him) once asked a Bedouin who had left his camel untied: “Why do not tie your camel?” The Bedouin answered: “ I put my trust in Allah.” The prophet then said: “Tie up your camel first then put your trust in Allah.” This conversation depicts not only how Muslims should accept their fate but it also indicates how Muslims can reduce the risk of loss and calamities.
The history of the prophet’s migration to Madinah gives us other lessons on how the Prophet managed the risk. The prophet reduced the risk of getting attacked by asking Hazrat Ali (RA) to sleep in his bed during the night of emigration. It was reported that as night advanced, the Quraish posted assassins around the Prophet’s house. Thus they kept vigil all night long, waiting to kill him the moment he left his house early in the morning, peeping now and then through a hole in the door to make sure that he was still lying in his bed.
All these above examples depict that risk management is in the roots of Islam. We, as Muslims, should put our trust onto Allah only after meticulous planning and best utilization of all the available resources.
(1) To protect the safety of the Takaful fund;
(2) To ensure the fund is able to pay claims and obligations;
(3) To achieve a required rate of return on investment if possible;
(4) The ability to withstand an adverse conditions; and
(5) To ensure continuity as a going concern.
Most Takaful operators classify their risks into three headings: namely the Takaful (business) risk, financial risk and operational risk. Identifying and classifying the risk in Takaful is important as it will enable them to manage the risk more effectively. Approaches to risk management may include having a common language in terms of concepts, definition and classification; adopt a wide disciplined approach; creating and instilling a strong risk governance; focused on aspects that is quantifiable and seek for continuous improvement.
In this sense, the industry is able to share the best practice among Takaful operators. Adopting the appropriate approach will make risk management more relevant, practical and acceptable. The important techniques of risk management adopted by the Takaful operator are self-assessment risk, asset liability management, solvency capital, re-Takaful or risk transfer program, key risk indicators warning the business on possibility of risk and any losses and business continuity management. The recent trend for the Takaful operators is to adopt Enterprise Risk Management (ERM). There is a growing demand from shareholders and senior management to implement ERM in their organizations as this means formalizing the essential connection between the business operations and its overall risk management program.
The initial stage of ERM is mostly about compliance and corporate governance and this may include the Shariah compliance. ERM has emerged as a new paradigm for managing the portfolio of risks that face the organizations and policy makers continue to focus on mechanisms to improve corporate governance and risk management. ERM is the process of planning, organizing, leading, and controlling the activities of an organization in order to minimize the effects of risk on an organization’s capital and earnings. ERM expands the process to include not just risks associated with accidental losses, but also financial, strategic, operational, and other risks. ERM could be considered as a systematic approach for managing risk. If the risk were to be managed effectively, companies may possibly achieve their corporate objectives and eventually create value for their stakeholders. The prominent issue in Takaful is the Shariah non-compliance risk. Whatever classification given to the Shariah compliance risk, the issue is pertinent in the overall Takaful operations.
Risks specific to Takaful undertakings
Most of the risks to which a Takaful company is exposed are similar (except for their incidence) to those of a conventional insurer relating to the management of those risks, including at a minimum underwriting risk (including provisioning risk), market risk, credit risk, operational risk and liquidity risk, as well as, potentially, legal risk, risk to the reputation of the insurer, and internal or intra group risks. Certain risks on the other hand are specific to Takaful companies. These include Shariah non-compliance risk, risks arising from the segregation of funds, and risks relating to the use of re-Takaful.
Shariah non-compliance risk is unique to Takaful companies as compared to their conventional counterparts. Breach of Shariah principles may render contracts invalid under Shariah, deprive a participant of Takaful protection, cause loss to the entity, damage its reputation, and expose it to regulatory action, and may have repercussions on the incidence and management of other risks. Shariah non-compliance risk is relevant to the product development process of a Takaful company.
A Takaful company seeks competitive advantage over conventional insurers as well as its Takaful counterparts. In seeking to meet the demand for innovative products, a Takaful company could inadvertently introduce Shariah non-compliance in its products. Shariah non-compliance risk is also relevant to the investment function of a Takaful company. The limited availability of Shariah compliant investment instruments may make a Takaful company susceptible to choosing an investment product whose Shariah compliance is questionable, when seeking to achieve adequate investment yield.
Another specificity of a Takaful company that requires specific attention is the separation of funds attributable to participants from each other and from those attributable to shareholders. This structure differs from that of a conventional insurer in which shareholders’ funds are invariably available to support insurance activities. The segregation of these funds in a Takaful undertaking brings with it a set of agency risks that differ from those in a conventional insurer and require separate consideration in the undertaking’s risk management framework. In view of this agency relationship, fairness and transparency are essential features of Takaful.
The specific nature of the Takaful industry raises further considerations. The development of the Takaful industry has been accompanied by differing views as to the validity under Shariah of the use of conventional reinsurance by Takaful and re-Takaful undertakings. In addition, differences have emerged in the manner in which individual re-Takaful contracts are affected and the attribution between funds, in both the ceding and reinsuring undertaking, of revenues and expenses ancillary to the actual risk-sharing transaction, such as commissions. Takaful companies need to ensure that the attribution of such revenues and expenses is transparent to participants and also (in view of the complexity of this aspect of business) that the fairness of the attribution is considered objectively.
In addition to the need for a Takaful company to consider the credit risk exposure to re-Takaful providers, if the principle adopted under the re-Takaful contracts is one of risk sharing with other cedant Takaful companies, rather than risk transfer, the Takaful company needs to consider the quality of risk selection and pricing exhibited by the re-Takaful provider, since inadequate control over these matters could expose the Takaful company to losses arising from the operations of other Takaful companies in the same risk pool.
A Takaful operator also needs to consider, having in mind the interests of participants, the financial status of any risk pool into which it proposes to share risks. The selection of re-Takaful providers should therefore be subject to due diligence and appropriate governance, with monitoring of exposures to individual providers and risk pools.
CEOs of Takaful operators often express their dissatisfaction with the contributions made by their firm’s risk management framework and capability to the success of the enterprise as they do not see quantifiable results. The combination of people and processes intended to support the business in dealing with uncertainty is often not perceived to be optimal.
The other challenge is the independency of the risk function that is not mandated by many of the regulators because of which risk framework cannot work independently of the business to provide a transparent and independent view of the business to the stakeholders.
Risk management is proving difficult for Takaful companies due to a shortage of knowledgeable, specialist staff, especially across the Middle East and Africa. This is according to new research conducted by the Economist Intelligence Unit on behalf of State Street Corporation, which found a quarter of respondents from the Middle East and Africa region struggled to find suitable risk personnel with Takaful expertise.
In line with Shariah requirements and the concept of Takaful, risk management practice and management of a Takaful operator should be better off than a conventional insurance operator. Protection that is in accordance with Shariah needs to be integrated into the Islamic finance activities. Takaful operators need to be proactive in managing their risks as part of good governance and best practice code. Self-regulation is needed rather than depending on regulatory requirements.
As risk is an on-going process, continuous development of knowledge is required in order to understand and manage the risks effectively. Irrespective of the business model adopted by the Takaful operators (Mudarabah or Wakalah or hybrid), the risk management will be the same since the basis is Shariah.
If the risk management framework components and the people operating the components are effective, then effective risk management should be achieved in the business activities of the firm. Improved risk management effectiveness should therefore be measurable in these activities by way of strong business performance, better decision making, improved risk adjusted return and better preparation for further uncertainties.