AM Best, noting that Takaful uptake across the Middle East and South East Asia is clearly on the rise, has issued its draft proposals for updating its Takaful rating methodology. The report highlights the main issues that arise when applying AM Best’s rating methodology to Takaful companies, on the assumption that despite the similarities with conventional mutual operating structures, Takaful companies offer distinctive issues that need to be highlighted, observed and rated separately.
What is clear with AM Best’s methodology is that although Takaful companies are given special dispensation for their overall operations regarding their adherence to the principles of Shariah; the Best’s Capital Adequacy Ratio (BCAR) methodology still takes precedence in AM Best’s overall analysis and credit rating of each operator. Utmost in AM Best’s consideration is an assessment of the company’s overall financial strength ratio (the operator’s ability to meet their financial obligations), the current underlying domestic and regional market conditions and the regulatory environment.
Dispensation is given on the understanding that Takaful products and operators are still in the earliest stages of development and have not yet reached sufficient capacity to compete on a level playing field with conventional insurance companies and their offerings. As with conventional mutual insurance, Takaful insurers have several limiting features inherent to their business model, such as a relative lack of financial flexibility in investments, or increased risk concentration. Given the comparatively restricted investment policy of a typical Takaful company, their higher levels of counterparty risk, geographical concentration, and higher than average proportion of stock holdings, capital requirements in many cases are significantly larger than for a conventional company of similar size.
The limited classes of invested assets have long been a barrier to the growth for the Takaful industry, as well as a limitation on the development of more long-term products, due to the difficulty in addressing asset-liability management issues. The current situation has improved as the capital markets in Islamic countries have begun to mature and more Shariah compliant investment products are available in the market. However, demand is still higher than supply, resulting in increased expense for such investment products.
One of the key characteristics of a Takaful operation is the existence of two separate funds: the Takaful fund and the operator fund. This creates a situation whereby any analysis of a company must be taken as a two-stage risk-based capital approach. By comparing the Takaful fund’s surplus to the capital required to support the fund’s obligations to the participants an assessment of a Takaful company’s balance sheet strength can be reached. Meanwhile, the operator’s fund is subject to a second-tier capital assessment comparing the surplus position of the operator’s fund to the capital required to support the fund’s obligations.
As with conventional insurance operations, an important driving factor in the rating decision for a Takaful company is its degree of financial flexibility (i.e. the company’s ability to raise equity capital). Restrictions in the operator’s financial flexibility and limited investment profiles are critical in this aspect.
Overall, one of the unique challenges facing Takaful companies is the need to ensure that the objectives set by an operator’s Shariah board are consistent with key performance indicators based on conventionally sound financials and risk management. That includes establishing processes to address all material risks, despite challenges presented by the limited capacity of re-Takaful, and including concentration risks presented by restrictive investment guidelines and the limited diversity of the current Takaful marketplace.
Going forward, AM Best believes that the main opportunities and challenges for the sector overall are the development of more robust life insurance platforms and compulsory lines such as third party motor and health liability. Critically, its analysis has not yet ascertained whether Takaful companies offer any competitive advantage with the market environment, suggesting that it is debatable whether there is actually any untapped demand (especially in the Family Takaful business) due to strictly religious beliefs – and whether this can be unlocked easily through the greater availability of Takaful products. — SW