Models of Takaful in Bangladesh Perspective

Milliman look into Report Prep ard by Safder Jaffer Farzana Ismail Jabran Noor Lindsay Unwin Re believeed by Debo Ajayi November 2010 Takaful ( Muslim Insurance) Cin whiz casept, Ch solely toldenges, and Opportunities Takaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 Takaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 Milliman interrogation Report limit EXECUTIVE SUMMARY 2 BACkgROUND AND MARkET OUTLOOk 3 PRINCIPLES AND PRACTICES UNDERLYINg TAkAFUL TAkAFUL OPERATINg MODELS 11 ISSUES AND ChALLENgES FACINg ThE TAkAFUL INDUSTRY 15 demonstration 25 APPENDIX I gLOSSARY 26 APPENDIX II BIBLIOgRAPhIC REFERENCES 28 APPENDIX III SELF REgULATINg BODIES &038 TAkAFUL gROUPS 29 Takaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 1 Mil liman explore Report exeCutive nerve centermary Through backdrop research, integrity b atomic number 18lyt end get a plethora of materials and papers on Takaful, however most scarper to focus either on the rudiments of Takaful or on Takaful sets.In contrast, the objective of this report is to highlight the depict outs and challenges face the world of Takaful and suggested beas where work is required to find resultant qualitys. thitherfore this report is intend to impart useful reference material for practi wizrs by summarising the fol humbleding cardinal items An overview of Takaful and the intricacies of the lessons Insights into the issues and challenges facing the Takaful industry Finding sustainable solutions to round of these challengesTakaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 2 Milliman investigate Report BaCkground and merchandise outlook Moslems accou nt for around 25% of the worlds originamental community, much thanover despite rapid egress in recent years, indemnification sales inwardly the Muslim population remain a small fraction of the total damages policy market. Historically, the repulsion surrounded by formulaic restitution and key tenets of the Islamic faith has acted as a probatory barrier to sales.These differences restrain led to in truth low penetration rates and nonplus left m whatsoever Muslims with little outside(a) egis for their dependents or possessions. The evolvement of Takaful, which originates from the Arabic verb kafalah, which means to help wholeness a nonher or mutual fix, has been driven by a impoverishment to overcome these obstacles and fix an policy policy policy proposition that is fully compliant with shariah (Islamic law). It rack upers Muslims a valuable essay bear awayment tool and the first true(a) option to formulaic amends in cardinal the disembodied spi rit and non invigoration sectors that is unexceptionable to the Muslim faith.For non-Muslims, Takaful products capablenessly offer an preference source of insurance protectionwith different enthronisation objectives, an come near to surplusage distri exclusivelyion, and an oversight trunk with an honorable dimension. and past in Malaysia, for example, non-Muslims account for much than 60% of the total Takaful bountys. Takaful offers Muslims a valuable try dealment tool and the first true alternate(a) to received insurance in both the behavior and non- smell sectors that is acceptable to the Muslim faith. approximate 1 geographiCal spread oF muslims as a % oF total population No data 0-5% 5-10% 10-50% 50-75% 75-100% Sources U.S. State Department, CIA WORLD FACTBOOK, Swiss Re Economic Research &038 Consulting Market Size and Outlook Whilst Takaful started in 1979 in Sudan, it lone any(prenominal)(prenominal) put one overed momentum in early 2000 when the Malaysian g overning promoted it and world-shaking growth was witnessed in that respectafter. The growth of Takaful has varied signifi washstandtly from country to country and its success, or another(prenominal)wise, has been largely dependent on the knowingness and affluence of the local population, as tumefy as on the robustness of the local restrictive theoretical account. Hence the highest growth has been observed in places much(prenominal) as Malaysia (with its considerable awargonness ofTakaful and robust regulatory framework), whereas growth in the Middle east has except recently begun to take off. Depending on the definition of Takaful, the ongoingly quoted volumes in equipment casualty of premiums mountain orbital cavity from USD$1 billion to USD$5. 6 billion. Although the exact size of the Takaful market has often been disputed, on that point is general acknowledgment of the rapid growth of the industry. In 2007, Takaful premiums in emerging markets grew by roughly 26% and accounted for 5% of insurance premiums Takaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 3Milliman Research Report written in Muslim countries. 1 concord to Takaful Re, a Dubai-based Retakaful smart set, Takaful premiums crossed the USD$3 billion mark in 2007 as seen in the table in Figure 2. Figure 2 takaFul premiums (usd$ millions) gCC 2004 2005 2006 2007 770 Saudi-Arabian ARABIA 1,238 1,579 2,046 645 1,065 1,340 1,695 KUWAIT 54 83 90 124 UAE 31 42 65 109 QATAR 25 34 50 76 BAHRAIN 15 15 34 59 south east asia MALAySIA 474 544 692 951 343 412 534 797 INDONESIA 77 75 80 94 THAILAND 30 30 32 35 24 27 30 35 aFriCa BRUNEI 121 181 215 317 levant 14 17 21 32 5 8 11 18 1,384 1,988 2,518 3,364 indian suB-Continent total Source Takaful ReThe intercommunicate Takaful written premium estimates consider often been debated by practitioners because of the considerable range of numbers published by mi xed sources. at that place is clog in determining degraded estimates of the total industry potential as thither is a wide-cut variety of Takaful definitions and categorisation, as well as a lack of consistent and credible data. Oliver Wyman suggested in a recent pack that the Takaful premium potential is at least USD$20 billion whereas Swiss Re in its annual Sigma report sees a potential of USD$56 billion. Takaful premiums by 2015 be estimated to be in the range of USD$7 billion to USD$8 billion.Hence it is necessary to exercise caution when analysing projected figures. Takaful turn ins glide slope to a large, relatively untapped market, in which insurance penetration hovers somewhere well below 2% of gDP, and its growth in the planetary market is evaluate to continue in the long term. Takaful brooks access to a large, relatively untapped market, in which insurance penetration hovers somewhere well below 2% of GDP, and its growth in the global market is expected to conti nue in the long term. Global estimates for the growth of the worldwide Takaful industry come in at 20% per year, cold outstripping the 2. % annual growth for unoriginal insurance premiums. 2 It is followinging to note that m all Takaful providers prevail emerged largely hale from the fiscal crisis, as enthronisations are normally held in highly legato assets, which is callable to hold sharia-compliant investitures. Insurers considering entry to the Takaful market are better off assessing the markets and opportunities sooner rather than later. Targeted merchandising and consumer education are essential to develop market awareness and established insurance brokers can leverage their existing marketing and distri exactlyion platforms.The lack of a clear market leader in Europe and the UK means that insurers can take advantage of the challenges and opportunities present in a developing global industry. 1 2 Swiss Re (2008). Insurance in the emerging markets. Sigma, Issue No . 5. PricewaterhouseCoopers (2008). Takaful Growth opportunities in a dynamic market. Retrieved Nov. 3, 2010, from http//www. pwc. com/en_GX/gx/financial-services/pdf/pwc_takaful. pdf. Takaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 4 Milliman Research Report rinCiples and praCtiCes underlying takaFul Principles primal the Takaful Industry The Islamic financial Services Board (IFSB), a self-regulated placement in Islamic pays, produced a paper on governance (in celestial latitude 2009) and defines Takaful as follows Takaful is the Islamic counterpart of pompous insurance, and exists in both Family (or invigoration) and superior general forms. Takaful is derived from an Arabic word that means joint countenance, whereby a pigeonholing of actors agree among themselves to choke off one another jointly for the personnel casualtyes arising from specify insecuritys.In a Takaful arrangem ent the participants contribute a sum of money as a Tabarru commitment into a prevalent parentage that depart be employ reciprocally to aid the members against a specified showcase of loss or damage. The underwriting in a Takaful is thus underinterpreted on a mutual basis, similar in some respects to conventional mutual insurance. A typical Takaful undert analogousg consists of a dickens-tier anatomical structure that is a hybrid of a mutual and a technical form of comp either which is the Takaful agent (TO) although in pattern it could be a sheer mutual structure.Hence thither is a recognition that whilst the current Takaful concept and rule is in supervenerence a hybrid of a mutual and mercantile insurer, in principle it necessitate to move more towards a pure mutual structure. This will be analysed later when discussing the opportunities and challenges of the Takaful industry. thither is a common misunderstanding that insurance or encounter mitigation is not allowed under Islam, as Muslims believe that only God knows ones future and faith. The following conversation interpreted from the sayings of the seer Muhammad depicts an interesting message as to why Muslims should indeed debase the happen of lossWhilst the current Takaful concept and practice is in fact a hybrid of a mutual and commercial insurer, in principle it needs to move more towards a pure mutual structure. Prophet Muhammad asked a Bedouin who had left his camel untied, Why do you not tie your camel? The Bedouin answered, I put my trust in God. The prophet and so said, Tie up your camel first and consequently put your trust in God. Every family has take a chance centering needs and, with the evolution of time, the methodologies also evolve.Almost 10 centuries forwards the advent of conventional insurance companies, the Muslim societies in Arabia take concepts of risk of exposure mitigation such as hilf to assist dupes of natural disasters or hazards of adm inister journey. another(prenominal) common practice widely use in Islam was al-aqilah. chthonic the custom of al-aqilah, it is in return agreed that, if a person is killed unintentionally by another person, the paternal relatives will take the responsibility to make a mutual role for the purpose of devoteing the blood money to the victims relatives.This practice of having a fund that consortiums voices from a group of mass to assist others in need is akin to mutual insurance. It is important to focalise out that the mutual attention was not originally a commercial execution and did not extend each get ahead or gain at the disbursal of others. Rather it evolved as a useful neighborly practice to mitigate the burden of an individual by dividing it among mate members. at that place are certain key issues inwardly conventional insurance that Islam does not permit Riba, or usury The first of these is the earning of interest, referred to in Islam as Riba.It is a conce pt expressly require at several points in the leger. traditionally viewed from the perspective of a loanword, Riba is considered unfair and inequitable to the borrowing party and and then earning interest is forbid under sharia law and Muslims must ward off Riba in all of their financial proceeding. gharar, or un matter of course The second broker is the presence of timidty embedded in the design of conventional insurance products. Uncertainty and the trading in risk are claned as Gharar, a concept command in sharia law law to protect participants from godforsaken or unjust transactions.Conventional insurance is designed around the transfer of risk in return for a premium, and the timing, severity, and/or frequency of assure events are each subject to Takaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 5 Milliman Research Report varying degrees of uncertainty. The light that insuranc e products commonly contain unclear contract foothold furthers the view that a high take of uncertainty pervades all aspects of conventional insurance. Maisir, or gambling link up to Gharar is the concept of Maisir, also prohibited under Islam, which captures those transactions with an underlying gambling or speculative nature. In the context of life insurance, many contract designs can be viewed as gambles which ultimately do good one side of an insurance contract at the expense of the other. For example, by taking out a term assurance contract, the risk is transferred to the insurer for a unbending premium and the payment of a small sum could potentially yield a disproportionately large payout, benefiting the policyholder at the expense of the insurer.Alternatively, the payment of a stream of premiums for many years could result in no return at all, which benefits the insurer. haram, or forbidden Conventional insurance designs whitethorn have investments in a number of asse t classes that pertain in activities prohibited at heart the Muslim faith, such as investments in alcoholrelated companies, pornography, or gambling-related enterprises such as casinos. Such activities are considered Haram or forbidden in Islam, and consequently, the proceeds of the conventional insurance are also deemed to be unacceptable in the Muslim faith.There is a further focus in Takaful (and in Islam in general) around the importance of moral values and ethical motive as trading is meant to be conducted openly in accordance with the extremity good faith, honesty, full disclosure, truthfulness, and fairness in all dealings. It is not within the scope of this report to look into the sharia matters in depth as there is a diversity of look on the exact principles of Takaful. There are some schools of thought within Islam that allow conventional insurance so long as it does not involve Riba (or usury) whilst others have a range of tolerance with some of the key issues menti oned above.However, by and large, there is patient of consensus on the solution to these issues. This emerged in the late 1970s in Sudan, but gained more prominence in the 1980s in Malaysia and the Persian disjuncture countries in the form of Takaful. Instead of paying an insurance premium, Takaful participants (policyholders) donate their Takaful contribution to a common crime syndicate to mutually assist the members against a delimit loss or damage. Takaful can thus be seen as the Islamic counterpart of conventional mutual insurance (i. e. , insurance that is compliant with the shariah law).Takaful is not a type of insurance but rather an alternative to insurance. It has to exercise on cooperative principles and incorporate the concept of Tabarru (donation, face). Instead of paying an insurance premium, Takaful participants (policyholders) donate their Takaful contribution to a common puss to mutually assist the members against a defined loss or damage. It is a one- style transaction which does not expect a definite return on the donation, strange the more traditional bilateral conventional insurance contract where a premium is paid in return for an insurance benefit.The pooling does perish Gharar, as the uncertainty virtually future claim events certainly tranquillize exists but now is acceptable as the donation (Tabarru) is meant for mutual assistance and not for profittaking or gambling (contracts of charity are not affected by the parapet of Gharar). However, remote conventional insurance where the risk is transferred to the insurer, all participants mutually share the risk in Takaful, which is an important fundamental difference. Takaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay UnwinNovember 2010 6 Milliman Research Report The chart in Figure 3 summarises the key differences amid conventional insurance and Takaful. Figure 3 Comparison oF Conventional insurance policy a nd takaFul Conventional insuranCe takaFul A risk transfer mechanism whereby risk is transferred Based on mutuality hence the risk is not transferred but from the policyholder (the check person) to the insurance shared by the participants, who form a common pool. The troupe (the insurer) in circumstance of an insurance company (takaful street girl) acts only as the coach of premium paid by the ensure person. the pool.In effect, the policyholders are both the insurer and the insured. Contains the voice of uncertainty, i. e. , gharar, which The element of uncertainty, i. e. , gharar, is brought d have got is forbidden in islam. The basis of the contract are to acceptable trains under shariah by characterising unclear as to certainty of when any loss would occur contributions as donations (Tabarru), not obligations, and and how much give would be payable. for a good cause, i. e. , To mitigate the loss suffered by any one of the participants, as opposed to payments linked to d efinite expectation of insured benefits to be received.Contains an element of gambling, i. e. , Maisir, in that the The participant pays the contribution (Tabarru) in the insured pays an amount (premium) in the expectation spirit of neea (purity) and brotherhood to go on mutual of gain (compensation/payment against claim). If the losses of members of the pool. Losses and gains are anticipate loss (claim) does not occur, the insured loses mutually shared by the pool members who contribute the amount paid as premium. If the loss does occur, to the pool. That is, third parties (insurers or reinsurers) the insurer loses a far larger amount than collected as re not affected by the outcome of risk events. premium and the insured gains by the same. investment companys are mostly invested in fixed interest-bearing Funds are only invested in non-interest-bearing, i. e. , instruments such as bonds, fixed interest securities, etc. Riba-free, instruments. Note that regular income hence these contain the element of riba (usury), which is investments are still possible (such as under forbidden in islam. Sukuk, islamic bonds) as long as the income is not interest-based. inordinateness or profit belongs to both the shareowners and spare belongs to the participants and is accordingly he with-profit policyholders. The insured is covered returned to them. during the policy period but is not entitled to any return at the end of such period. The concept of shariah law (Islamic law) complaisance is an evolving one and is overseen by the Islamic scholars that sit on the shariah law supervisory Board, which provides the final certification of compliance. The scholars base their views primarily on the principles of the Quran, supplemented by hadith (the teachings of the Prophet), Fatwas (judicial credits of shariah law scholars), and Islamic jurisprudence on economic transactions. small-arm the words of the Quran and Sunnah are sacrosanct, the independent reasoning of shar ia scholars can be revoked or adapted to suit changing circumstances, and overbold victimizations are dealt with by legal reasoning and judgment of Shariah scholars. This creates a moving goalpost, which is one of the challenges in the Takaful industry which will be discussed further in division 4. Takaful provides Shariah-compliant solutions to the prohibited concepts with conventional insurance while still protecting against uncertain events in return for a commensurate fee.The mutual guarantee offered by Takaful is centred on a transparent, ethical, and Shariah-compliant agreement amid the i mover and participants. Takaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 Takaful provides Shariahcompliant solutions to the prohibited concepts with conventional insurance while still protecting against uncertain events in return for a commensurate fee. 7 Milliman Research Report Practices in the Ta kaful Industry This section provides an overview of the components and current practices in the Takaful industry, including Practices within Family Takaful (Life) and General Takaful Shariah-compliant assets Retakaful Retro-Takaful Family Takaful (Life) and General Takaful As introduced above, conventional insurance as sold in horse opera markets is fundamentally irreconcilable with several tenets of the Islamic faith. In terms of life insurance, Shariah scholars view these contracts as a gamble on the insureds life. There is uncertainty surrounding when and if death will occur within the covered period, and in the event that no claim is do the policyholder is considered to have made a loss.For Muslims, this incompatibility rules out traditional life insurance as a means of obtaining protection for their dependents. Family Takaful offerings provide access to life insurance coverage in a manner which does not mesh with their religious beliefs. Takaful is incorporated around t he core principle of sharing and pooling mortality rate/ morbidity risk with fellow participants rather than transferring it to a profitoriented corporate entity. Takaful is structured around the core principle of sharing and pooling mortality/morbidity risk with fellow participants rather than transferring it to a profit-oriented corporate entity.The concept of mutual support allows many parallels to be drawn between Shariah-compliant Takaful military operations and mutual insurers. However, unlike mutual insurers and friendly societies, current Takaful operations involve shareholders who have a profit motive, who provide the peachy and fund the administration of the risk pool, and who are separate from the participants. Hence, Takaful operations can be viewed as Shariah-compliant commercialised mutual insurance operations. This structure of necessity, which is due to the need for roof, creates another set of challenges to be discussed further inSection 4. Similar to the conce pt of with- internet products sold by mutual insurers, Family Takaful is designed to combine protection for the benefit of ones dependents with a savings element and requires the dispersal of surplus to participants. However, the requirement of transparent disclosure of charges makes Family Takaful contracts akin to the clear charging structure underlying a unit-linked insurance contract. Current practice is to develop Shariah-compliant variants of conventional insurance products.Family Takaful variants of most common life products, including level and decreasing term assurance, savings and retirement plans, and critical illness coverage, have been successfully launched in various markets. For example, a direct contribution entitle of savings scheme offering equity flick could be substantial by limiting investment to spud issued by companies that meet the non-Haram or Halal (lawful) requirements. Even product designs, such as annuities and whole life plans, whose inherent char acters include an uncertain duration, are presently being considered as Takaful offerings.A consequence of mutuality, voluntary contributions, and absence of third parties (such as the insurer in conventional insurance) to share in the risks is that Family Takaful contracts cannot (or do not) offer guarantees to the participants. Guarantees on investment returns, fillipes, risk charges, or premiums, etc. , are not offered under Takaful products. While Takaful practice allows the spread of risk through with(predicate) reinsurance from Retakaful companies, or conventional reinsurers on a necessity basis, this practice is not to allow guarantees as the reinsurance pool is seen as an extension of the primary risk pool.Accordingly, investment returns on contributed property by the participants are based on actual investment experience. However, the Takaful actor is obligated to advance a loan (qard), on an interest-free basis, to support any shortfalls in the risk pool in meeting cl aims. This implicit guarantee of underwriting risk by shareholders of the Takaful operation creates some weakness in the current commercial get of a Takaful operation. Commonly, while there are no guarantees, there are expectations established at point of sale through product illustrations. Takaful (Islamic Insurance) Concept, Challenges, and Opportunities SafderJaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 8 Milliman Research Report However, the concept of mutual assistance does not prohibit the use of underwriting and prospective pricing based on experience studies. As with conventional insurance, if the health of a potential participant would result in epochal additional strain being pose on the underwriting fund then an extra contribution would be required. The prohibition of interest-bearing instruments does not impact on the use of interest functions in pricing or valuation of long-term liabilities in Takaful.The pricing interest assumption is based on ex pected returns from Shariah-compliant assets underlying the liabilities. In terms of surplus distribution, any distribution made to participants is based rigorously on actual surplus arising. As long as the underwriting fund is not in deficit, surplus arising from both investment and underwriting activities can be used to make a cash payment to participants and/or contribute to any claim fluctuation check. The latter is set up to cover short volatility in the size and incidence of payments out of the underwriting fund.As with regular bonus declarations on conventional with- gain contracts in the UK, surplus distributions, if any, are most commonly made on an annual basis. Participants in a Takaful operation will need to be countenancely and comprehensively educated on this feature of the product design so that reasonable expectations are built up as to the level of distribution. Shariah-Compliant Assets The avoidance of Riba, Gharar, Haram, and Maisir in the design of Takaful pr oducts has a significant impact on the investment decisions of a Takaful operation. constituents must be invested purely in Shariah-compliant assets, i. e. , assets that are non-interest-bearing and whose returns are not derived from activities considered unethical. Haram or forbidden investments in Islam include financial derivatives such as futures and options, interest-bearing bonds, and equity issued by companies partaking in non-Halal business activities as described earlier. The development of the Sukuk market and a robust Shariah-compliant stock selection process together offer Takaful providers an more and more feasible solution to this investment conundrum.Contributions must be invested purely in Shariahcompliant assets, i. e. , assets that are non-interest-bearing and whose returns are not derived from activities considered unethical. Shariah law forbids loan issues that are at a discount to their nominal value and, as already discussed, completely restricts the earning of interest (Riba). These two statuss effectively rule out conventional corporate or government bonds. The expanding Sukuk market offers access to an asset class which shares some properties with conventional bonds and others with equity stock, whilst remaining Shariah-compliant.Regular Income Assets Sukuk are issued via the creation of a special purpose vehicle (SPV) by an issuing bank that has been approached by a company or government seeking supporting for a item project. Sukuk certificates are then issued in return for an investors funding contribution, and rank alongside the banks other senior, unsecured debt. Sukuk instruments are structured to provide a direct link to the assets that underlie the particular project and through this link confer shared ownership of these assets to the investor.Investors then receive a regular income based on a soft touch rate of return. incomplete this income nor the return of roof on maturity is guaranteed and both will typically vary in line with the revenue of the company (or equivalently the return on or value of the underlying assets). This potential naval division is partially offset by the ability of the Sukuk manager to build up reserves when revenue overcomes the lay rate, which can be subsequently used to make up shortfalls. Sukuk provides the Takaful market with a legitimate investment alternative to government and corporate bonds.Several issues surround these Sukuk, such as availability, control, and ownership. These issues impact their boilers suit effectiveness in supporting long-term liabilities, especially income annuities. Takaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 9 Milliman Research Report Equities A Takaful floozie does not need to seek an alternative investment in order to gain exposure to equity-type risk and return.Equity stock does not pay interest and offers direct participation in the pro fits of a listed business whether through dividends or growth in the scathe of the stock. However, restrictions do exist in relation to the type of company a Takaful wheeler dealer may invest in to remain Shariah-compliant. To gain exposure to equity returns Takaful doers or their investment managers must apply a natural covering process to eliminate stocks of companies that are exposed to forbidden industries or divulge certain financial conditions.The industries deemed to be non-Shariah-compliant include banking, insurance, gambling, and those linked to pork, alcohol, or tobacco. The financial screening looks at key financial ratios of a particular company, such as conventional debt ratio and the sum of the interest and non-compliant income compared to total revenue. Where these ratios exceed limits located down by a companys Shariah Supervisory Board, the equity issued by the company in question is excluded from tolerable investment.This screening is a continual process, as the evolving nature of a firms business practices and neat structure mean that its status as either compliant or noncompliant is not static. Real dry land and Mortgages Although there are Shariah-compliant forms of investments in real estate and mortgages, these are currently under-utilised but have significant potentials. Retakaful By entering into a reinsurance contract, conventional insurance companies are able to share risk, gain capital support, or benefit from a broader base of experience in areas such as pricing, underwriting, and claim management.Historically, Takaful operators have sometimes also had to make use of conventional reinsurance owing to the lack of a Shariah-compliant alternativethis exception was based on the dharura or necessity principle. The growth in the Retakaful market offers a solution to this problem. Retakaful provides these same facilities to Takaful operators but within a structure that remains Shariah-compliant and in a manner specifically tai lored to the particulars of the Takaful market. In the same way as Takaful rovides a vehicle for participants to provide support to and share their own risk with a pool of other members, Retakaful allows Takaful funds to share risk among multiple Takaful pools. In the same way as Takaful provides a vehicle for participants to provide support to and share their own risk with a pool of other members, Retakaful allows Takaful funds to share risk among multiple Takaful pools. In this regard, the operation of a Retakaful fund is very similar to that of a direct Takaful fund.A Retakaful fund must have a Shariah Supervisory Board and the criteria it must satisfy to be considered Shariah-compliant mirror those to which a Takaful fund must adhere. The Retakaful fund receives contributions from each participating Takaful fund and distributes back surplus arising from investment and underwriting activities utilize one of the models described later in this report. Further, if the Retakaful fun d goes into deficit then the Retakaful operator is required to make an interest-free loan or Qard Hasan to the fund to eliminate this shortfall.Re-Takaful operators may not pay commission to a Takaful fund with which it is engaged. In recent years there has been a significant growth in global Retakaful capacity, owing to major reinsurance companies such as Swiss Re, Hannover Re, and Munich Re entering the market. Their entries will help facilitate further expansion of the Takaful market, and the capital support and depth of advice that these players can offer will be invaluable in setting up an operation, wherever the chosen market. Retro-Takaful more or less Retakaful operators retrocede conventionally on the basis of necessity because currently there is extra Retro-Takaful capacity available. There is talk of a Lloyds syndicate for Retakaful players that would imply retroceding each others business to reduce volatility and provide the spread of risk, but this has yet to material ise. Takaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 10 Milliman Research Report takaFul operating modelsThe basic structure of a Takaful scheme involves the policyholders or participants enlisting a Takaful operator to practise the necessary investment and underwriting roles. Family Takaful, the Shariahcompliant equivalent of life insurance, is commonly structured so that a participants contributions are apportioned between two segregated funds the investment fund and the underwriting fund. An individual (investment) account is keep for each participant with the contributions made, net of any upfront fees. From this account, risk charges are deducted to be deposited into the pooled underwriting fund.Contributions paid into the underwriting fund are considered to be made on the Tabarru basis, to support all participants in their exposure to mortality/morbidity risk. whatever covered claims suffered by the participants are paid from the underwriting fund to avoid the conveyance of risk. The basic structure of a Takaful scheme involves the policyholders or participants enlisting a Takaful operator to perform the necessary investment and underwriting roles. The sharing of risk with fellow participants is in contrast to full or partial transfer of the risk to a proprietary company.This also means that if the underwriting fund is short to pay claims then no recourse can be made to shareholder assets. However, in practical terms, to prevent closure of the fund, the deficiency is covered by a temporary interest-free loan (Qard Hasan) provided by the Takaful operator. This would be repaid from future surpluses arising within the underwriting fund. Nevertheless, this arrangement acts as a strong motivator for operators to properly manage the fund, thereby limiting the possibility of devising future loans.Takaful is most commonly structured using the following models The M udarabah model This is a Proprietary or Partnership model that considers the Takaful operator as a business checkmate with the participants. It is structured on classic profit-sharing principles, i. e. , a partnership model where the participants provide the capital, while the Takaful operator provides expertise and management of the Takaful fund. A contract feature how underwriting surplus and investment profits are shared between operator and participants, similar to conventional insurance (with-profits or articipating business). The Takaful operator shares in the investment and underwriting surpluses via a predetermined ratio mutually agreed with the policyholders at outset. Neither the operator nor the participant can unilaterally alter this agreed sharing ratio, which is unremarkably explicitly set out in the contract at outset. From the perspective of the participants, they do not contribute right off to the operators addresss and all contributions are effectively availa ble to meet claims.Correspondingly, the operator can generally only expect to make a profit by ensuring that the expenses of managing the operation are less than the total share of investment profit and/or underwriting surplus it may receive. If the underwriting fund runs into deficit then the operator is obliged to provide an interest-free loan or Qard Hasan, to be repaid once the fund is in surplus. The Wakala model This is an Agency model that treats the Takaful operator as an agent of the participants tasked with the administration of the Takaful fund, for which it is compensated through a fixed fee.The operator does not share in the risk nor in the surplus generated from the two funds (investment and underwriting) but instead receives a fixed up-front fee (commonly a percentage of contributions paid) to cover management expenses, distribution costsincluding intermediaries remunerationcost of capital, and a margin for operational profit. This fee must be pre-agreed and is commo nly expressly stated in the contract. This fee can vary by product and some contracts can change over time. Competitive consideration predominates in the setting of the level and structure of this fee.On the whole, the operator will be profitable if the fee it receives is greater than its incurred expenses. Theoretically, the Takaful operator bears no insurance risks itself. The risk-bearing is seen as a process of solidarity between participants and takes place solely among the collective of insured persons (therefore the name joint guarantee). However, due to the obligation to make up for any deficits in the pooled underwriting fund, the insurer is indeed exposed to a non-negligible insurance risk it might not be able to recuperate a Qard Hasan if insufficient surplus is generated Takaful (Islamic Insurance)Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 11 Milliman Research Report over time. Furthermore, no interest c an be charged on the neat loan, but this is one of the very intrinsic principles of Islamic finance that has to be strictly followed. In reality, therefore, the Takaful operator under a Wakala model bears more risk than the designers of the model may have intended. In the extreme, the underwriting fund can be underfunded to create perpetual deficit in the fund thus making it the responsibility of the Takaful operator to be at risk perpetually.The diagram in Figure 4 compares a typical Family Takaful structure using the Mudarabah and Wakala models. Figure 4 Comparison oF mudaraBah and Wakala models Participants Participants Investment Fund d on at urp nt S me Ta b ar io n Underwriting Fund Surplus shared in predetermined ratio between participants and operator operator est ru Inv urp nt S me est Inv ar Contribution Investment Fund ru d s&038 ent rplus ym Pa g Su im in Cla erwrit d Un Ta b s&038 ent rplus ym Pa g Su im in Cla erwrit d Un Contribution us Wakalah Model lus Mudarabah M odel on at io n Underwriting Fund Wakalah Fee (% of Contribution) Operator In the 1980s, in a pioneering Takaful regulatory development in Malaysia, scholars initially accepted the more commercial Mudarabah model. However, recently there have been concerns raised by scholars that Mudarabah may not be appropriate because of the fact that Takaful is supposed to create a surplus and not profits, and underwriting surplus is prohibited as this arises from insurance risk.Therefore the element of profit-sharing of underwriting surplus by the Takaful operator within the Mudarabah model is deemed to be not Shariah-compliant. The pure Mudarabah model seems more akin to a business venture rather than a mutually based contract based on solidarity of its participants, which would imply that the Tabarru is working capital and is arguably not in the spirit of a donation. Furthermore, the kindred between policyholders and operators lacks transparency. The development of Takaful n the Middle East t ook shape later in the 1990s, with the touristed preference towards a Wakala model. The development of Takaful in the Middle East took shape later in the 1990s, with the popular preference towards a Wakala model. The Wakala (agency) framework emerged as the dominant model, and Malaysian scholars have moved in spare of this model too. However, in late 2004, some scholars particularly those in Pakistan, Bangladesh, and second Africabegan to highlight deficiencies with the Wakala approach.As a result of the recent findings in the Takaful industry, there have been many variations of Mudarabah and Wakala developed by practitioners to address the limitations. The variant Takaful models considered in this section are Takaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 12 Milliman Research Report Variant Mudarabah model A variant of the pure Mudarabah model would be to limit the profitsharing element such that it is only applied to the investment portion, which would then be fully in line with Shariah.However, this model might not be commercially viable as it is likely that the income generated from the investment portion will be insufficient for the Takaful operator. Another variant of this model would be to charge the operating expenses directly from the Takaful fund instead of funding it from the shareholders fund (i. e. , the underwriting result is net of Tabarru, claims, Retakaful, reserve adjustments, and operating expenses).The type and amount of expenses charged to the fund should be laid out to the participants in a transparent manner, although there are concerns about the type of expenses that can be charged to the fund. With the Mudarabah model, there is also the difficulty in managing fixed expenses alongside a variable and potentially vaporific surplus, although this feature indirectly encourages the efficient management of the Takaful operation. However, given the many commercial challenges facing the pure and hybrid Mudarabah models, many Takaful operators have opted for the Wakala structure. Wakala with incentive fee model Critics of the pure Wakala model cite the lack of incentives for the operator to manage the Takaful fund efficiently as the operator does not share in any profits. The operators income is a fee, which is based on employee turnover (i. e. , Takaful contributions). Therefore, the Takaful operator may be driven to write large amounts of new-sprung(prenominal) business without due regard to proper underwriting or claim management (although to some consequence this action is deterred through the commitment of an interest-free loan or Qard).To encourage the operators to apply appropriate underwriting and investment approaches, some operators have adopted a Wakala model with incentive compensation, where the Wakala fee is adjusted (upwards) in the grammatical case of an underwriting and investment surplus. This performance- related fee would not be permitted under a pure Wakala model though the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI, the self-regulatory body) recognises that an incentive fee is permissible. To encourage the operators to apply appropriate nderwriting and investment approaches, some operators have adopted a Wakala model with incentive compensation. Wakala Mudarabah model (hybrid) This is the most popular model today for Family Takaful operators, where a Wakala is applied on the underwriting fund and a Mudarabah on the investment profit. Specifically, the operator charges a Wakala fee from the Takaful contributions and all underwriting profits are distributed back to the participants. However, investment profit is shared between the participants and the operator based on a predefined ratio.There is an appeal within this model as investment profits are usually the major source of income for Takaful operators, whereas underwriting results can easily be managed using quota share Retakaful arrangements. Wakala with Waqf model The main issue in the pure Wakala model is that the element of Gharar (uncertainty) is not fully eliminated because the contribution (treated as a donation) remains in the participants ownership and is effectively a conditional donation. Hence the participant can expect to receive the surplus back, which therefore becomes a conditional gift.However, there is uncertainty about the level and timing of the surplus it will receive. Secondly, there is a blood between the participant and operator and another amongst participants (exchange of gift for a gift). This creates doubts on the Wakala contract as a contract of compensation. The relationship of the Takaful operator with the participants is ambiguous because none of the participants are liable for the repayment of the outstanding loan. To overcome these concerns, Pakistani scholars developed the idea of a hybrid Wakala-Waqf model to remedy some of these i nherent disadvantages.This model requires the setting up of a Waqf (endowment-trust or independent pool) that becomes the nucleus for the relationship between the participant (donor) and the operator (i. e. , both have obligations towards this trust). A Waqf is a well recognised Shariah entity which has the ability of accepting ownership or appointing ownership of asset. The objective of the Waqf is to provide relief to participants against defined losses as per the rules of the Waqf fund. By setting up a Waqf, the following advantages are derivedTakaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 13 Milliman Research Report ? The relationship of participant and operator is with the Waqf fund (i. e. , ambiguity removed) ? Donation of participant to the Waqf is innate (Gharar removed) ? Operator can be a Mudharib (or manager) of the investments of Waqf and can share in the investment profits ? Con tingency reserves within the fund may be set up ? Cross-subsidy of various generations of policyholders is permissible ?Surplus distribution can be predefined on a variety of criteria with the primary condition that the operator does not get any share as a Wakeel (or representative) to the Waqf fund Currently this model is widely used in Pakistan and mho Africa, and has also been adopted by the Swiss Re Retakaful branch in Malaysia. Which Model to Choose An operator can choose any of the above-stated models but the pickax depends on many factors, such as the point population, regional acceptance, Shariah display board views, regulatory framework, product design, marketing, and pricing.As outlined above, the most common models are the Wakala and Mudarabah model or a hybrid of both Mudarabah model is less acceptable globally but perhaps more bewitching as profit is shared with the policyholders. However, there is a strong opinion of scholars from especially the Middle East that underwriting profit cannot be shared with the operator as it stems from donations. The Wakala model is by far the most recognised and has the ordained effect of providing a fixed and steady income stream. However, in its purest form it has hold upside potential as the only source of income is the Wakala fee.This could harm fighting as a high up-front Wakala fee might look unpresentable to participants and have adverse effects to new entrants because of the high initial costs. There has been an increasing trend towards the hybrid model which is based on the occupation of the Wakala model for the underwriting portion and the application of the Mudarabah model for the investment part. Considering that investment income usually makes up the bulk of the profits, this model is viewed by many Takaful operators to be commercially viable.This is widely practiced in the Middle East and Malaysia and accepted by virtually all scholars across the world. The AAOIFI has also endorsed hybri d versions of Wakala models. In all models, although not mandated by Shariah, the Takaful operator is commonly expected to provide an interest-free loan in case of a deficit in the underwriting pool. In all models, although not mandated by Shariah, the Takaful operator is commonly expected to provide an interest-free loan in case of a deficit in the underwriting pool.This expectation requires alert risk management techniques as there is uncertainty in terms of the amount and timing of the loan to be repaid from future surplus arising. Takaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 14 Milliman Research Report issues and Challenges FaCing the takaFul industry The issues and challenges facing the Takaful industry are considered separately under the following sections I. Key Issues and Challenges II. Technical Issues and Challenges III.Other Issues and Challenges I. key Issues and Challenges rough of the key issues and challenges facing the Takaful industry are a. b. c. d. e. f. g. h. Lack of consumer awareness scarcity of kind-hearted resources with both insurance and Shariah expertise The dearth of Shariah scholars with appropriate experience Lack of calibration in the industry that is due to Shariah interpretations Diverging regulatory approaches and the lack of centralised regulations Solvency and capital requirements incorporate governance Shortage of suitable assets These are discussed in further detail below. . Lack of consumer awareness Despite the introduction of Takaful, the increase in the level of penetration anticipated has yet to be realised. Many consumers are still unaware of Takaful as an alternative, and some view Takaful as commercialisation of conventional insurance into the Islamic world and reject the notion that it is a Shariah-compliant instrument. In addition, many individuals tend to downplay the importance of security and retirement form ulation and many are also heavily dependent on the tender security systemsthis is particularly evident in the Middle East.Similar to conventional insurance, Takaful coverage is typically a proposition that needs to be sold to consumers (instead of one that is bought by consumers). There is a need to fundamentally address educational issues surrounding Takaful and individual risk management amongst the Muslim societies, to develop consumer awareness. some of the current education on Takaful is among interested or related practitioners and investors, and very few awareness campaigns are aimed at or designed for the quarry population.Similar to conventional insurance, Takaful coverage is typically a proposition that needs to be sold to consumers (instead of one that is bought by consumers). b. Scarcity of human resources with both insurance and Shariah expertise Future growth may also be hampered by the currently narrow pool of professionals with sufficient Takaful knowledge in area s such as law, sales, and actuarial services. Most operators would typically employ human resources, such as legal advisors and actuaries, with conventional insurance experience.These resources would typically tend to learn the Shariah aspects of Takaful and adapt their previous experience to incorporate Shariah compliance rules in their new role. Hence the mindset of most operators tends to be driven by conventional thoughts and solutions and, as a result, there has been limited original thinking in the industry. Recently, there have been various Takaful courses offered, including one offered by the Chartered Insurance Institute (CII), which will assist in the development and creation of human resources with both insurance and Shariah expertise. c.The shortfall of Shariah scholars with appropriate experience Every Takaful operator requires a Shariah Supervisory Board, which is typically comprised of three or more Shariah scholars. For a Takaful operator with regional ambitions, the need to build credibility in the quarry market means there are preferences for the board members to originate from the target markets or at least have experience in the target market. Scholars would ideally have experience and knowledge not only in Islamic jurisdictions but also in Takaful. This is essential as board members are responsible for certifying the Shariah compliancy of the business operations.However, the number of Shariah scholars with experience in both Islamic jurisdiction and insurance is limited inevitably, these scholars are currently sitting on multiple boards, which may create conflicts of interest and Takaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 15 Milliman Research Report compromise the quality of advice. The shortage in scholars remains a short-term barrier on new entrants and drives up the cost of setting up a Shariah board. As the Takaful industry has only recentl y been stablished, there is a wide range of issues currently being debated amongst Shariah scholars and technocrats, particularly those surrounding the definitions and practices that are deemed to be acceptable and Shariah-compliant. d. Lack of calibration in the industry that is due to Shariah interpretations As the Takaful industry has only recently been established, there is a wide range of issues currently being debated amongst Shariah scholars and technocrats, particularly those surrounding the definitions and practices that are deemed to be acceptable and Shariah-compliant.For example, the inconsistency of Shariah interpretations can be seen in the following issues Issues that are due to regional differences There are significant regional differences in consumer attitudes and the extent of tolerance and innovation in the Takaful industry. For example, Malaysia is sensed to be more liberal and willing to embrace modern conventional concepts within the Takaful framework. In c ontrast, the approach in the Middle East countries is more conservative, with less willingness to embrace modern conventions.This creates challenges in transferring solutions across regions. Issues in the choice of Takaful models There is a variety of models that may be adopted by the Takaful operator in the industry, as discussed in Section 3. There is a wide variation in practices and model preferences in various countries, which is due to the varying interpretation by scholars. For example, in Saudi Arabia, the regulatorsSaudi Arabian Monetary Agency (SAMA)approve a cooperative model in which only 10% of the surplus is mandatory for distribution to policyholders.Some scholars would argue that this model does not meet the requirements of Shariah compliance. For instance, there are no specific Shariah compliance requirements for assets. yet Takaful operations are still possible, and some have been approved, within the broader cooperative model framework. Similarly in Iran (where t he integral legal system is Islamic-based), Takaful remains an unknown concept as the Shia Islamic school of thought (as practiced in Iran) does not view conventional insurance to be non-Shariah-compliant.However, despite these regional variations, there is a global trend elsewhere towards a Wakalabased model without any sharing of the underwriting profits. This approach has also been formally approved by the AAOIFI, which is a step towards standardisation. However, a global standard for Takaful models remains to be seen, which is due to the varying opinions and interpretations of Shariah scholars around the world. Issues about the source of capital There is a wide variety of issues that are subject to Shariah interpretations.One of the debates amongst scholars is whether it is necessary for the original capital in a start-up Takaful provider to be Shariah-compliant. In practice some scholars typically do not question the initial source of capital as this would impede the operatio n of global players. Instead, the scholars would usually only swan on the usage of capital to be fully Shariah-compliant. Issues surrounding the type of risk deemed acceptable in Takaful Another topic of debate amongst scholars s the type of risks that are deemed to be acceptable within Takaful, and this issue chiefly relates to General Takaful. As the concept of Takaful is to mutually guarantee all participants, there is an argument that for large risks where the number of participants is limited, those risks may not fall within the concept of Takaful. For example, Takaful coverage for government-owned projects where all the participants within the pool are government agencies may not essentially achieve the concept of mutual guarantee (as arguably there is only one participant in the pool, the government).There is a debate on whether there should be a distinction between Halal (lawful) and Haram (unlawful) risk, and if prior screening of risks is necessary for acceptance within the Takaful pool. Related to the lack of standardisation in types of acceptable risks is the lack of uniformity in the definitions of insured events and exclusions. For instance, in Family Takaful treatment of suicide, Takaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 6 Milliman Research Report AIDS, and contestability is non-uniform. This complicates the pertinency of pricing assumptions based on experience statistics drawn from conventional business and complicates pooling of experience among Takaful operations with differing underwriting and contract definitions. Issues surrounding Wakala fees and the cost of capital Another issue that is constantly debated is the extent of expenses that can be charged by the operator as Wakala fees and whether the cost of capital can be included.Some Shariah scholars have argued that the operator cannot charge participants for the cost of capital, which r aises the question of the commercial viability of Takaful operators. Some Takaful operators would also choose to allow for a profit margin to be embedded within the Wakala fees, and there is further debate on the extent that this is tolerable within the bounds of Shariah. The opposing views of Shariah interpretation in different regions make Takaful standardisation even more difficult to achieve, particularly for global companies wishing to provide similar product bases across various regions.This lack of standardisation in Takaful may undermine the credibility of the industry, and may have a subsequent negative impact towards consumer protection, transparency, disclosure, and the overall moral philosophy of insurance. e. Diverging regulatory approaches and the lack of centralised regulations In the absence of standardisation of a global Takaful regulatory regime, the industry is relying heavily on the opinion of the Shariah boards of the Takaful companies, subject to any local reg ulatory constraints. Local regulators have adopted a variety of approaches when it comes to dealing with Takaful.There are three key categories of regimes The opposing views of Shariah interpretation in different regions make Takaful standardisation even more difficult to achieve, particularly for global companies wishing to provide similar product bases across various regions. 1. A level playacting field approach, such as the Financial Services Association (FSA) in the UK. This is the most common approach by regulators in predominantly non-Muslim countries. The FSA has adopted a no obstacles, but no special favours approach in handling Takaful business and will regulate Takaful operators within its current regulatory framework. . A pragmatic middle ground, such as the Bank Negara Malaysia (BNM), in Malaysia, where the regulators have adopted a comprehensive Islamic financial system running parallel with the conventional system, with an evolving attitude to regulations over time. 3 . A more specific tailor-made approach, such as the Central Bank of Bahrain (CBB). The CBB has taken the lead in considering the unique characteristics of Takaful companies and aligns the regulations of Islamic insurance as far as reasonably possible.It is useful to note that based on a level playing field regulatory approach, the FSA has outlined in its November 2007 return entitled Islamic Finance in the UK Regulation and Challenges, three potential challenges in regulating the Takaful industry Whilst Takaful products may appear similar to conventional products, the structure of the Takaful offerings and operations are fundamentally different compared to conventional products The role and responsibility of the Shariah Supervisory Board should be purely informatory (i. e. , not executive roles) The marketing and promotion of Takaful products must be fair, transparent, and not misleading, in the spirit of the treating customers fairly principle collectible to the variety of re gulatory approaches, there is an incentive to develop a centralised global regulator for the Takaful industry. There have been talks within the industry particularly verbalized by practitioners at various conferences and seminars for the need to standardise the Islamic finance industry, with aims to develop standards and guidelines for Islamic financial institutions and regulators.These are mainly driven by four organisations (details of each of the following are provided in Appendix III) Takaful (Islamic Insurance) Concept, Challenges, and Opportunities Safder Jaffer, Farzana Ismail, Jabran Noor, Lindsay Unwin November 2010 Due to the variety of regulatory approaches, there is an incentive to develop a centralised global regulator for the Takaful industry. 17 Milliman Research Report Rulings of the Islamic Fiqh honorary society of the Organisation of Islamic Conference (OIC) Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) Islamic Financial Servi ce