Such comments reflect the ongoing struggle between theory and practice: the challenge to balance Shariah requirements and objectives against the demands of the economic world, which is more often than not dominated by the conventional insurance system and where competition is fierce. Takaful expert Ajmal Bhatty once referred to it as “the battle of hearts and minds.”

Takaful practitioners have been taught that Takaful is built on cooperative, risk-sharing principles, we are not supposed to take a share in the underwriting surplus; we should provide a qard hasan (benevolent loan) if there is a deficit in the Takaful fund and that we will be repaid through future surplus arising from that fund.

But we were soon realizing that all this is probably not the way Takaful actually works in practice. Regulators and industry bodies have now come up with new guidelines and regulations with the aim to provide more structure and guidance, enhance corporate and Shariah governance, as well as facilitate standardization. For example:

• AAOIFI
  – Draft amendment of AAOIFI Shariah Standard No 26 (Islamic Insurance)
• Central bank of Malaysia, Bank Negara Malaysia (BNM)
  – Takaful operational framework
  – Shariah governance framework
  – Draft of the risk-based capital framework for Takaful operators
• I will not discuss the details of these regulations but rather pinpoint certain features that are at odds with the general perception of Takaful.

AAOIFI amendment on surplus sharing
The AAOIFI, at its recent Shariah conference in Bahrain this May, proposed an amendment of the AAOIFI Shariah Standard No 26 (Islamic Insurance).

Rather surprisingly, this would allow the sharing of underwriting surplus with the Takaful management if a certain performance benchmark is exceeded.

Somewhat puzzling is the distinction that surplus shall only be shared with the management and not with the shareholders — the ones who put up the capital for the Takaful operation in the first place. The rationale might be an underlying Jualah contract, where the incentive goes to the performing party only. In practice, this distinction might be somewhat irrelevant as the incentive is likely to be offset against the managers’ remuneration or expected to be gifted (hibah) to the shareholders.

Overall, the proposed amendment is a welcome progression from AAOIFI’s previous stance as surplus sharing has been one of the most contentious issues, dividing the Takaful industry into two different schools of thought that hindered standardization. Instead of tackling its operational deficiencies, the industry was caught up in theoretical model discussions. Considering that surplus sharing has been common practice in Takaful markets like Malaysia, Indonesia, Saudi Arabia and Brunei, the new ruling is long overdue and allows the industry to finally move forward. In the meantime, scholars might want to discuss further if there is an alternative to the current Tabarru (donation) principle that is the root of the underlying ownership issues.

The AAOIFI ruling mitigates the principal-agent conflict to some extent, which is imminent under the pure Wakalah model. The pure Wakalah is a volume driven model, independent of the actual claims experience. This misalignment in financial objectives creates fewer incentives for a commercial Takaful operator to implement advanced risk and claims management techniques.

In fact, it puts him into an ethical dilemma — maximizing the fee income by accepting as much business as possible or applying more stringent underwriting and claims measures to ensure that the Takaful fund remains solvent. As long as there is no proper governance framework, it is open to abuse. BNM has acknowledged this issue and released new regulations that will tighten corporate and Shariah governance in Malaysia.

For instance, there are too few scholars and a concentration on the few prominent ones. This has often resulted in delays and inefficiencies in the Shariah approval process. In addition, resolutions were not as elaborate as one would expect. Indeed, proper Shariah resolutions are hardly available. Despite the fact that Islamic financial institutions (IFIs) claim to be more transparent than their conventional counterparts the approval process and underlying ruling is a black box for most stakeholders.

Furthermore, the Shariah committee is perceived as being not as independent as one might expect as the management is often in the driver’s seat. Maslahah mursalah (public interest), urf (custom) and dharurah (necessity) are principles probably applied one time too many to justify contentious transactions requested by management to cope in a fiercely competitive environment.

Lastly, innovation seems to be lacking as product developers are too focussed on mirroring halal versions of conventional products, not least due to the lack of knowledge about Shariah principles.

BNM has released a Shariah governance framework that directly addresses the current shortcomings. It is somewhat ironic that Malaysia, who is often accused of keeping one eye closed when it comes to Shariah compliance, has sidelined critics by taking the bull by the horns. The framework is illustrated below.

Major changes affecting the IFIs are as follows:

• IFIs are asked to establish a Shariah committee (SC) of at least five learned scholars instead of three as previously. To avoid conflicts of interest, a scholar cannot sit on multiple committees.
 This is a challenge for IFIs who are struggling to fill the quota due to the scarcity of qualified scholars. It may sound contradictory but the aim actually is to overcome the current shortage. IFIs are now forced to engage more junior scholars and this will increase the pool of available talent over time.  It also aims to ensure that the committees work more efficiently as Shariah research and approval work can be delegated to the junior members.

• The SC is now directly reporting to the board of directors (BOD) and the board has ultimate responsibility for Shariah compliance. This aims at providing a higher degree of independence of the SC and an avenue for escalation to mitigate any undue influence by the management. It remains to be seen how effective this is in practise as BOD and management might have similar financial objectives.

• A more effective measure is the requirement to conduct a regular (annual) Shariah audit by internal or external auditors. This adds pressure on the SC and management to ensure that Shariah resolutions are properly reasoned, documented and implemented. Moreover, IFIs have to establish a permanent Shariah review function. The Shariah risk management function identifies all possible Shariah non-compliance risks and, where appropriate, proposes remedial measures to reduce the risk.

• The lack of transparency is addressed by the requirement to publish sufficient information on the state of Shariah compliance in the financial report, such as based on the audit report findings.

• Lastly, an internal Shariah research team has to be established to conduct research on Shariah. This is to overcome the ongoing criticism that Islamic finance lacks innovation and is merely copying conventional products.

Overall, this is the most comprehensive Shariah governance framework of all Takaful markets and underlines the sincere efforts of BNM to put more structure into the Takaful industry after it has been given some leeway in its early years.

Good governance naturally comes at a cost and Takaful operators will have to manage the additional burden on finances and resources properly. IFIs will incur additional compliance costs; costs that their conventional counterparts do not have.

It will also slow down the time-to-market for products and thus put IFIs at a structural disadvantage vis-à-vis their conventional counterparts. As such, one cannot speak of a level playing field anymore, even more so in view of the new solvency and operational frameworks.

One requirement however, is at odds with the Shariah and this underlines the quandary of both the regulator and the Takaful industry when implementing Shariah requirements: The provision of a qard in case of a deficit in the Takaful fund has become mandatory under this framework. To complicate matters, the framework requires operators to write off in full any outstanding qard after a certain number of years (five years being the unwritten rule) regardless of whether one can expect to recuperate parts of the loan in the future or not. Interestingly this requirement seems to be even stricter than the impairment of financial assets rules under IAS 39 (replaced by IFRS 9).

Furthermore, it effectively puts the Takaful operators on the same level as a conventional insurer as the underwriting risk is shifted from the Takaful fund to the shareholders’ fund. This means a breach of a fundamental Takaful principle.

One might argue that the risk of a qard is negligible but this is not necessarily the case for Takaful funds with volatile risks, such as commercial risks, or small funds as Takaful operations are often new setups that have yet to achieve a critical mass. It applies even more so to a re-Takaful operator as such volatile risks are mostly ceded out. Munich Re is currently engaging with AAOIFI to clarify and to overcome this dilemma of risk sharing versus risk transfer.

While the mandatory qard is probably the necessary evil the industry has to deal with for solvency purposes, BNM surprised the industry by mandating that re-Takaful has to be based on pooling of business across multiple Takaful operators.

This may not sound surprising to some as risk-sharing is one of the fundamental pillars of Takaful.

However, in practice Takaful operators have been opposed to the pooling concept and often insisted on not being pooled with other cedants. Just like in conventional reinsurance, where there is no pooling.

Risk-based capital framework
The RBC framework builds on the TOF and basically mirrors the RBC framework for conventional insurance companies. It follows the common solvency formula
CAR = total capital available (TCA) / total capital required (TCR) x 100%,
where the central bank requires a minimum supervisory target capital level of  130%.

The main difference between insurance and Takaful RBC lies in the separate treatment of the participants’ risk funds (PRF) and the shareholders’ fund (SHF). The risk funds would usually be a separate fund for family and general Takaful business.

Further sub-funds may be created, however, it may negatively affect the solvency position as no cross subsidies are allowed as outlined further below.

The total capital available is the sum of the available Tier-1 and Tier-2 capital in the respective funds. Any qard from the shareholders’ fund would qualify as Tier-2 capital for the Takaful fund, however it would be deducted from the overall CAR to avoid double counting.

The shareholders (theoretically) are not bearing any underwriting risk but are responsible for expense overruns and any operational risks in view of their fiduciary responsibility. The required capital is thus the sum of the risk capital charges for the expense liability, operational, credit and market risk.

The regulator does not allow a cross-subsidy of different lines of business (such as Family and General) by restricting the TCA in a particular Takaful fund at the amount of TCR for that particular fund. That is, excessive capital in one Takaful fund (basically retained valuation surplus or any claims stabilisation reserve) cannot be used to offset a shortfall in another Takaful fund.

The TCA of the SHF is not restricted and any capital required for a CAR above 100% would thus have to be met out of the SHF. Considering that BNM requires a supervisory minimum level of 130% and internal target capital levels of usually around 180% to 200%, it means that the additional 30% to 100% would have to be fully covered by shareholders’ capital. This puts Takaful operators at a significant structural disadvantage compared to conventional companies.

It also poses the question as to who actually owns the risk — the shareholders or the Takaful participants?

The Takaful industry has to continue its efforts to raise Takaful awareness and enhance transparency to convince the regulator that it deserves a fundamentally different treatment in view of the perceived lower risks of Takaful due to its risk-sharing feature.

Lastly, there are still a number of “white elephants in the room” that the industry and scholars have been reluctant to address as there are no easy answers.

Examples are the mandatory qard, the costs of capital for solvency capital, the question whether re-Takaful is actually risk transfer or risk sharing or whether the Tabarru contract should be reconsidered.