Takaful: Insurance revolution in Islamic finance

Islamic Finance Industry: Alpha & Omega
The enactment of the Islamic Banking Act in 1983 spawned a new paradigm of banking in Malaysia. The establishment of the first Islamic bank (namely Bank Islam Malaysia) in 1983 and subsequently Takaful Malaysia in 1984 provided an alternative means for Shariah compliant fund placements and management.

Since its inception, the industry has gained staggering momentum and Malaysia is currently regarded as a leading contributor in the Islamic finance industry. This development has mainly been driven by the government’s efforts in promoting the industry and providing incentives to boost growth.

The Islamic finance industry has various components but the most notable is Takaful, which makes Islamic finance unique. Currently there are 12 Takaful operators in Malaysia (with four new licenses issued since 2009) and 4 re-Takaful operators. Bank Negara Malaysia (BNM) indicates the Takaful industry has been growing rapidly, appealing to both Muslims and non-Muslims. The industry is expected to grow by 15-20 percent annually, with contributions expected to reach USD7.4 billion by 2015.1

Speaking in Kuala Lumpur in April 2011, the former deputy governor of BNM, the late Datuk Mohd Razif bin Abd Kadir, indicated the Takaful industry had a compound average growth rate of 27 percent in terms of net contributions between 2005–2010, with family Takaful driving growth at 28 percent for the same period and dominating more than 80 percent of the total Takaful market in 2010.2

Takaful & Re-Takaful: The Basis of Shariah Compliant Insurance
The prevailing needs of the Muslim community looking for a Shariah compliant alternative to conventional insurance accelerated the development of the Takaful industry in Malaysia. This, in addition to the uprising of the Islamic banking sector, boosted the Takaful industry to its present more refined and matured form.

In 1982, the Malaysian government set up a task force to study the feasibility of creating an Islamic insurance company. The move was triggered by the Malaysian National Fatwa Committee’s decree, which ruled the current form of life insurance a void contract due to the presence of the elements of Gharar (uncertainty), Riba’ (usury) and Maisir (gambling).3 This was further strengthened by the introduction of the Takaful Act enacted in 1984 and the incorporation of the first Takaful operator in Malaysia in November of the same year.

Takaful is a form of Shariah compliant insurance. The word originates from Arabic and is defined as ‘joint guarantee’. A Takaful fund is a fund in which participants contribute a sum of money to be used to assist participants against a defined loss or damage.

The operator entrusted to manage these funds on behalf of the participants usually earns a fee known as the agency or Wakalah fee. However, depending on the variations of the Takaful fund’s operations, some operators may also earn profit from the investment of its shareholders' funds, or receive a share of the investment profit or any surplus of the Takaful funds based on an agreed contract.3 In all instances, the operator is usually indemnified of any loses that the investment may incur.

The Takaful industry is broadly divided into family Takaful business (Islamic "life" insurance) and general Takaful business (Islamic general insurance). In Malaysia, Takaful operators have flexibility in choosing either the Mudharabah (profit-sharing) or Wakalah (agency) operational models in compliance with Shariah principles and prudential requirements.

The Mudharabah model, more commonly used in Malaysia and the Asia Pacific region, provides an incentive for the operator to perform careful underwriting, to manage claims judiciously and to limit selling expenses so as to increase its return on management/shareholder capital and efforts. The Wakalah model, used in the Middle East, is seen to be relatively more transparent since fees are clearly related to an operator’s operational costs.

Takaful Industry: Paving the Foundation for Islamic Finance
One area that remains prominent to the contribution of Islamic Finance is what the Takaful industry has to offer to the industry as a whole. In order for the Islamic banking industry to exist there needs to be a robust Takaful industry in place as the banking sector is highly dependent on the insurance industry both for revenue generation as well as risk transfers.

Secondly, the long term nature of Takaful liabilities, huge cash reserves and foreseeable premiums allows Takaful providers to serve as institutional investors injecting capital in Shariah compliant investment products and equities.

The law of economy dictates that where there is demand there will always be supply, and demand is the key aspect here. The lack of Islamic instruments in the current market has been largely seen as a hindrance in the growth of the industry. At the same time, there needs to be sufficient interest from the market to ensure that new Shariah based equities will be subscribed to should they be offered. A balanced equilibrium is highly dependent on the growth and funds available for investment in these new products.

One key shortcoming of the Islamic finance industry is the lack of Shariah liquidity management instruments. Some efforts like the recent establishment of the International Islamic Liquidity Management Corporation are set to counter this concern. Nevertheless, more effort is still required to promote liquidity in the Islamic financial sector. Takaful providers, which are usually cash rich, can fill in this gap by investing in Shariah compliant instruments like Islamic money markets or Sukuk funds to boost demand. This would, in addition, assist in new product innovations and development thus increasing the viability of the industry holistically.

Takaful Industry: Challenges to Consider
The modified Mudharabah concept currently used in the Malaysian Takaful industry has seen some resistance from traditional Islamic scholars, especially from the Middle East.4 Its opponents argue that since the risk taking is not shared between the rab’ ul Mal (capital provider) and Mudharib (fund manager) there exists some element of Gharar (uncertainty). Shariah principles dictate risk as a type of Gharar and managing it as part of a contract is also prohibited, thus rendering conventional insurance unacceptable.

At the same time, under the Takaful concept the funds belong to the participants and not the operator. This means the operator is technically not entitled to any surpluses the funds may generate. Nevertheless another counter doctrine by Imam Ahmad b. Hanbal states that people have the freedom to contract as long as there is willingness (Ridha) between them. The norm in regards to contracts and stipulation (‘Uqud Wa Shurut) is permissibility. Therefore people are at liberty to enter any contract and engage in any trade that they wish, whether this conforms an existing precedent or not4.

Another view propagates that participants cannot be promised a predetermined amount for their misfortunes under the Mudharabah concept. This is because the fund is a communal fund and participants have to be compensated based on the resources available to the group when a misfortune occurs.

On the other hand, supporters of the modified Mudharabah model argue that the variation allows for better risk management as the fund manager gains more profit if funds are managed effectively. This promotes profitability of the funds which in turn protects contributors.

Recent regulatory changes have also affected the Takaful industry, for instance the introduction of FRS4 and Solvency II would required Takaful Operators to be more transparent with additional regulatory disclosures. Many Takaful operators do not appear to have major concerns with the introduction of FRS4. However, the implications for the Takaful industry with the introduction of Solvency II is still within the gray area as several issues are currently not ironed out particularly in the area of capital regulations since the operating models for conventional insurance and

Takaful are significantly different
In the area of profitability, a recent study conducted by Ambest5 indicated that Takaful companies generally have a lower yield compared to their conventional counterparts. This is mainly attributed to higher restrictions imposed on investment opportunities for Takaful operators as compared to their conventional counterparts.

In their report they indicated that from 2004 to 2009 Takaful companies suffered greater capital losses, both realised and unrealised, in comparison to their conventional counterparts. Since 2006, conventional insurers in the Gulf Cooperation Council and Malaysia have delivered a better return on their investments. In 2009, Takaful companies had an investment yield of 3 percent, compared to a 5 percent return for conventional insurers. The study was conducted in key Takaful countries like Malaysia and the Gulf Cooperation Region.

Nevertheless, the outlook for Malaysian Takaful business is not all that gloomy, according to a report by Arab News,6 BNM’s 2010 Financial Stability Report indicated that total income for family Takaful increased from RM3,381.6 million in the fiscal year ending 31 December 2009 to RM4,030.2 million for the same period in 2010. This included net contributions for family Takaful which increased from RM2,719.8 million to RM3,326.9 million; net investment income which similarly increased from RM354.8 million to RM451.6 million for the same period; and profit on sales of assets which decreased from RM307.1 million in 2009 to RM251.8 million in 2010.

Profits generated by Takaful operator have also seen an increase in recent years. Etiqa Takaful for example saw their profit before tax grow by 18% to RM107 million in 2010 compared to RM90 million in the 2008/2009 financial year. Another operator Takaful Malaysia Berhad recorded a 28% improvement in its overall profit in 2010, from RM37.2 million recorded in the same period in 2009. Takaful Iklas saw its net profit surge by 8% in financial year 2010 as compared to 2009 closing at RM9.47 million while Prudential BSN Takaful Berhad recorded a profit of RM 13.9 million in 2010.

The Takaful Industry: The Road Ahead
The importance of the Takaful industry in providing real alternatives to foster the growth of Islamic finance is certainly worth exploring. The rise of Islamic banking, hand in hand with Takaful, is inevitable and it is only a matter of time before it gains sufficient momentum to provide significant challenge to the conventional Insurance industry.

While the Takaful industry still has a long way to go to achieve an equal footprint with conventional insurance, it has laid the foundations necessary to bridge the gap.
Despite the long road ahead, the future of Takaful does have a silver lining. One pivotal fact is that in order to succeed, the industry must re-invent itself. Operators need to design innovative products with transparent and competitive pricing while improving customer service. At the same time, it also needs to focus on standardising key operating methodologies and increase its risk management capabilities to succeed.

References:
1 Bank Negara Malaysia, Islamic Banking & Takaful https://www.bnm.gov.my/
2 Speech by Datuk Mohd Razif bin Abd Kadir, Deputy Governor of the Central Bank of Malaysia, at the Launch of ING Public Takaful Ehsan, Kuala Lumpur, 5 April 2011.
3 Islamic Banking & Takaful Department: 20 Years Experience of Malaysian Takaful Industry, 2004.
4 Ismail, Azman, Issues in The General Takaful Model, Presented at a workshop conducted by Bank Negara Malaysia
5 Essen, Yvette A.M Best Company, Takaful Special Report, 11 July 2011
6 Parker, Mushtak Arab News: Malaysia's Takaful market shows impressive growth, April 24, 2011.
7 Financial Reports of Individual Companies.