OPERATIONAL AND ACTUARIAL ASPECTS OF TAKAFULRegulations and Takaful Models.

Shariah Basis for Protection and Guarantee Insurance is aim at providing protection from future

unforeseen constraints upon the occurrence of an unexpected particular future risk

The following sayings by the Holy Prophet justified the concept of protection for those who are in need.

“Narrated by Abu Huraira (r.a.. the Holy Prophet(s.a.w.) said: whosoever removes a wordly hardship from a believer, Allah (s.w.t.) will remove from him one of the hardships of the day of judgement. Whosoever alleviates from one, Allah(s.w.t.) will alleviate his lot in this world and the next."

Shariah Basis for Protection and Guarantee One should strive hard in overcoming one’s

unexpected future risk or perils before leaving one’s destiny in the hand of Allah(s.w.t.)

“Anas bin Malik r.a. narrated that the Holy Prophet (s.a.w) told a Bedwin Arab who left his camel untied trusting to the will of Alah (s.w.t.) to tie the camel first then leave it to Allah (s.w.t.)

Takaful is not simply a Name Change

No Riba

No Gharar

No Maysir

Islamic trade and finance thrived in the 7th to 16th century guided by the principles propagated by Islam

The current revival of Islamic Finance necessitates the construction of a full set of acceptable financial instruments

Its implementation in accordance to Shariah principles

Prohibition of Riba“ ..Allah (s.w.t) permitted trade while prohibited Riba.” (Al-

Baqarah 2:275)

“…Allah (s.w.t) those who believe, deal not in usury, doubling and quadrupling the sum lent. Fear Allah, and you would be successful (Al-Imran 3:130)

Narrated by Abu Huraira (r.a.) “The Holy Prophet said: “if a person conducts two transactions contained in one, he should stick to the lower one or he will commit an act involving riba”

Prohibition of GhararThe Holy Quran has explicitly forbidden all

business transactions including injustice in any form to any of the parties, whether in the form of deceit or fraud or undue advantage or peril leading to uncertainty in the business or any dealing. (Quran: 6:151-152).

Hadith of the Prophet as narrated by Anas bin Malik states that the Prophet forbade the sale of fruits till they were almost ripe.

Prohibition of Maisir“ O you who believe! Intoxicants, gambling,

idolatrous practices and soothsaying are abomination of Satan’s handiwork. So avoid it in order that you may be successful.” Surah al-Maidah (5:90)

Concepts of Takaful The contract of Takaful is founded on the following

three principles:1. Mutual responsibility,2. Mutual assistance and cooperation,3. Mutual protection or guarantee.

Takaful Act 1984 (TA 1984)Enacted in 1984 and currently under reviewFollows closely the Insurance Act (amended in

1996)

Main Provisions under TA 1984Section 4 – Requirements for carrying on biz as a Takaful

operatorSection 8(5) – Registration of takaful operators by the

DG (must be Shariah compliant and establish an SAC)Section 11(a);(g);(h)- Cancellation of Registration if not

Shariah Compliant; carrying on biz detrimental to the interest of participants ; not able to meet it’s obligations.

Section 16- Establishment and maintenance of takaful funds, and allocation of surplus

Section 17-Requirements as to Assets of the Takaful Fund

Main Provisions under TA 1984Section 21- Establishment and maintenance of

Takaful Guarantee Scheme FundSection 23 – Re takaful Section 25- Assumption of risks (on General Biz)Section 35- Takaful agents and brokersSection 36 – Intermediaries in takaful

transactionsSection 42-Actuarial investigation and reports

Main Provisions under TA 1984Section 46 - Investigations of affairs of Takaful

OperatorSection 47 – Powers of the Director General to

issue directions (Guidelines)Section 53A - Advice of the Shariah Advisory

CouncilSection 60 – General provisions to offencesSection 66 – Knowledge or statements of agents

is deemed that of operator

BNM Guidelines (Sec 47)Guidelines on Directorship for Takaful OperatorsGuidelines on the Governance of Shariah CommitteeGuidelines on Prohibitions Against Unfair Practices in

Takaful BusinessGuidelines on Proper Advice Practice for Family Takaful

BusinessGuidelines on Operating Costs of Family Takaful

BusinessGuidelines on Financial Statements for Takaful OperatorsGuidelines on Related Party Transactions for Takaful

Operators

BNM Guidelines (Sec 47)Guidelines on Outsourcing For Takaful Operators

(Investments, IT etc…)Guidelines on Role of Appointed ActuaryGuidelines on Financial Condition Report (FCR)Guidelines on Min Standards and Disclosure for Health

TakafulGuidelines on Family Takaful Products

Main AAOIFI StandardsFAS 12- General Presentation and Disclosure in

Financial Statements of Islamic Insurance CompaniesFAS 13- Disclosure of Bases for Determining and

Allocating Surplus in Islamic Insurance CompaniesFAS 14- Investment FundsFAS15- Provisions and Reserves in Islamic Insurance

CompaniesFAS 17- InvestmentsFAS 19- Contributions in Islamic Insurance Companies

Main AAOIFI StandardsGSIFI 1- Shariah Supervisory Board:Appointment,

Composition and ReportGSIFI 2- Shariah reviewGSIFI 3- Internal Shariah ReviewGSIFI 4- Audit& Governance Committee for Islamic

FIsGSIFI 5- Independence of the Shariah BoardGSIFI 6- Statement on Governance Principles for

Islamic FIsCode of Ethics for the Employees of Islamic FIs

Shariah Advisory CouncilRoles and Functions

To advise the Board on Shariah matters in its business operation;

To endorse Shariah Compliance Manuals;To endorse and validate relevant documentations;To assist related parties on Shariah matters for advice

upon request;To advise on matters to be referred to the SAC;To provide written Shariah opinion;To assist the NSAC on reference for advice;

Contract/Models in TakafulThe contract defines issues such as:Who pays for the expenses incurred in the business

ventureHow profits are shared between the parties in the

agreementWho are liable for any losses arising from the

venture

Potential ModelsPotential Models Include:CooperativeWakalaMudharabaModified MudharabaWakala MudharabaWakala with incentive compensation

Potential Models

The Takaful Model would need to satisfy:Shariah ConcernsTechnical ConcernsRegulatory Concerns

Cooperative Model

Participant

Contribution (Premium)

Investment Profit

Participants Account

(Personal)Participants

Special Account

(Common)

Policy Benefits

Underwriting Surplus

Actual Management

Expenses

Operator

Investment Profit

100% 100%

Mudharabah Model

Participant

Contribution (Premium)

Investment Profit Participants

Special Account

(Common)Underwriting

Surplus

Actual Management

Expenses

Operator

Investment Profit

(1 – x)% 100%

x%

Participant Account

(Personal)

Policy Benefits

Wakalah Model

Participant

Contribution (Premium)

Investment Profit

Participants Account

(Personal)Participants

Special Account

(Common)

Policy Benefits

Underwriting Surplus

Operator

Investment Profit

100% 100%Wakalah Fee (to operator)

Actual Management

Expenses

Waqf Model

Participant

Contribution (Premium)

Investment Profit

Participants Account

(Personal)Waqf Fund

Policy Benefits

Underwriting Surplus

Operator

Investment Profit

100% 100%Wakalah Fee (to operator)

Actual Management

Expenses

Modified Mudharaba Model

Participant

Contribution (Premium)

Investment Profit

Participants Account (Personal)

Participants Special Account (Common)

Policy Benefits

Underwriting Surplus

Actual Management Expenses

Operator

Investment Profit

(1-x)%

(1-y)%

x%

y%

Mercer

Wakala Mudharaba Model

Participant

Contribution (Premium)

Investment Profit

Participants Account (Personal)

Participants Special Account (Common)

Policy Benefits

Underwriting Surplus

Operator

Investment Profit

(1-x)% 100%

x%

Wakala Fee (to 0perator)

Mercer

Wakala with Incentive Compensation

Participant

Contribution (Premium)

Investment Profit

Participants Account (Personal)

Participants Special Account (Common)

Policy Benefits

Underwriting Surplus

Operator

Investment Profit

(1-x)% (1-y)%

x%

Wakala Fee (to operator)

y%

Mercer

Potential Models

Models which may be of concern to some Shariah councils:Modified MudharabaWakala with Incentive CompensationThese models allow the Operator to share

in underwriting surplus which may not be allowed

Potential Models

Takaful Models which would be of concern to Actuaries:CooperativeMudharabaInsufficient income to the Operator

generally results from these models, as well as difficulties matching income and outgo

Potential ModelsThere may also be restrictions on the model

which can be used due to regulatory constraints. This would vary by country. Bank Negara currently favors the wakala mudharaba and wakala with incentive compensation models

Potential ModelsTakaful Models which should be universally

acceptable worldwide from a technical and shariah point of view:WakalaWakala with a Mudharaba in investments

profit

Simplified Profit and Loss – Pure Wakalah

Shareholders’ Fund

Life Fund (Par)

+Investment

Income-Expenses

+Premium+Investment

Income- Claims- Commissions- Management

ExpensesReserves

Profit/Loss Surplus/Deficit

Example :Conventional Insurance

Takaful Fund

+Contribution+Investment

Income- Wakalah Fees-Claims

Reserves

Surplus/Deficit

Operator’s Fund

+Investment

Income

+Wakalah Fees- Commissions- Management

Expenses

Profit/Loss

Takaful

Surplus shared by both Shareholders and Policyholders. Formula for allocation fixed by regulators

Surplus NOT shared with Operator

Sources of Income – Pure Wakalah

Takaful Fund

+Contribution+Investment

Income- Wakalah Fees

- Claims

Reserves

Surplus/Deficit

Operator’s Fund

+Investment

Income

+Wakalah Fees- Commissions- Management

Expenses

Profit/Loss

Takaful

Surplus NOT shared with Operator

Participant Account (Saving)

+Contribution+Investment

Income- Tabarru

Surplus

Risk Fund

+Investment

Income+ Tabarru

- Claims

Reserves

Surplus/Deficit

Simplified Profit and Loss (for illustration only)

Conventional Insurance Takaful

Surplus shared by both Shareholders and Policyholders. Formula for allocation fixed by regulators

Surplus NOT shared with Operator

This is not an indication of the profitability of an insurance company against a takaful operator.

Risk Management via Technical DesignIn terms of the technical design of the Takaful model:

With risks come rewards, no risks mean no rewardsThe key to success is to understand exactly what risks

are being taken and manage them appropriatelyThere is much more diversity in the risks taken by the

various Takaful operators compared to conventional insurers and other Islamic Financial Services

Risk Management via Technical Design(…contd)Certain risks will be present irrespective of model

chosen:-Expenses risksInvestment risksUnderwriting risksShariah risksRegulatory risksMarket risks

Risks Associated with ModelPossible risks:

InvestmentA Wakala model can be designed with incentive

compensation for good investment returnsA Wakala model with charges as a percentage of Net

Asset Value (NAV) also has investment riskA pure Mudharaba(on Investments) model hinges on

iinvestments income to succeedA modified Mudharaba model also contains

investment riskThus differing levels of investment risk can be taken,

with corresponding levels of rewards expected

Risks Associated with Model DesignMortality / Benefit Risk:

All models have some level of underwriting risk, as if experience is poor enough a Qardl Hasan loan will be given by the operator

A Wakala model can be structured to share in underwriting surplus, thus increasing mortality/benefit risk

A modified Mudharaba model generally has significant mortality/benefit risk

Risks Associated with Model DesignExpense Risk:

For most models management expenses and commission are paid from the operators fund. Thus expense risk is significant

In some models expenses are paid from the risk fund, thus passing this risk back to the participants

Risks Associated with Model DesignDistribution Risks

A complicated model might have excellent risk reduction features/be technically pleasing, but if it is too complicated for the distribution force to understand then sales will be affected

Similarly the model can be designed such that the products look very similar to conventional products or distinctly different depending on the needs of the distribution force

Risk Management via Technical Design(…contd)Insurers may vary risk exposures via the products sold:

Mortality risk may be the focus for insurers promoting mortgage reducing term plans

Investment risk may be the focus for insurers promoting participating products

Expense risk may be the focus for insurers promoting unit linked plans

Risk Management via Technical Design(…contd)

Medical and health risk may be the focus for insurers selling health plans and yearly renewable riders

Hence, Takaful Operators may focus on these risks and diversify via product development similar to conventional insurers, but may also address risk via the Takaful model chosen

Participant

Contribution

Actual Management

Expenses

Operator’s Fund

benefit payment(Death/TPD Benefit)

Wakalah FeesParticipants’

Fund

Yearly Investment Profit

(Mudharabah Basis)

surrender payment (less maturity charges),

expiring payment.

RiskFund

Monthly Tabarru’

Special ReserveFund

Monthly Walah

Qardhul Hasan Loan (if necessary)

*Annual Allocation

Note : * Subject to the recommendation by the Appointed Actuary

Yearly Surplus

HLTMT Business Model

How is it different from Conventional InsuranceThe Issues Conventional Insurance Takaful

Regulations Insurance Act 1996, BNM GPI and LIAM regulations

Takaful Act 1984, BNM JPIT and MTA regulationsShariah Standards may follow BNM SAC and AAOFII

Governance Structure

Board of Directors representing shareholders. Audit, Risk Mgt, Nomination and Renumeration is required under GPI 1

Board of Directors representing shareholders and SAC.SAC is required by the Act.Audit, Risk Mgt, Nomination and Renumeration is required under JPIT 1

Risk Management

Underwriting of risks.Invariably uses Reinsurance

If strictly. Operator just manage the risks and the investment fund. To mitigate larger risk exposure Retakaful is given priority. Doctorine of neccessity can allow Reinsurance.

Nature of Contract

Risk is tranfered to Insurer through a Buy and Sell contract

Participation in Risk Pool by making Tabarru’ . Gharar must be minimal

How is it different from Conventional InsuranceThe Issues Conventional Insurance Takaful

The “black box” 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.

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.

The investment Insurance companies usually invest in riba earning instruments and in companies involved in forbidden businesses.

No Riba investments and investments only made in accepted businesses (significant overlap with Socially Responsible Investments).

The benefits In some cases the policyholder makes a windfall as result of being eligible to claim under a policy.This has elements of gambling (maysir)

Strictly a contract of Indemnity. The participant may or may not claim under a Takaful contract.

Profitability Sources include experience gains,investment gains and expense margins.

Strictly, sources should be from wakalah fees, and profit sharing of investment returns

The End