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ECON 6864




SEM 1 2013/2014





















Contemporary takaful is a combination of a social security system and a risk management. It draws inspirations from two concepts from Islamic heritage; the Islamic brotherhood and the risk management in Islam. In the time of the Prophet and His Companions, due to the strength of the Islamic brotherhood, the social security was very strong in the community. Back then, should one fall sick or face hardship, his neighbours and other Muslim brothers would surely offer their assistance; be it in monetary, food, physical effort or others. Muslims do this out of their piety and love to each other. This is due to the teaching of Islam that enjoins Muslims to help each other in times of difficulty. This spirit is gloriously enshrined in both Quran and the Prophetic traditions. As narrated in one hadith:

“He who relieves the hardship of a believer in this world, Allah will relieve his hardship on the Day of Judgment. He who makes easy what is difficult, Allah will make it easy for him in the world and the Hereafter. He who conceals the faults of a Muslim, Allah will conceal his faults in the world and the Hereafter, for Allah helps the servant so long as he helps his brother. He who travels a path in search of knowledge, Allah will make easy a path to Paradise, for a people do not gather together in the houses of Allah, reciting the Book of Allah and studying together, except that tranquility will descend upon them, mercy will cover them, angels will surround them, and Allah will mention them to those with Him; and he who is slow to good deeds will not be hastened by his lineage.”(Sahih Muslim)

With regard to risk management, until now, it is a common belief to some Muslims that it is not allowed to mitigate risk hence all type insurances are impermissible. This is due to their confusion and lack of knowledge on the concept of predestination and the concept of risk in Islam. However, one only needs to look to the following hadith to know that managing risk has been allowed if not encouraged by the Prophet himself:

Prophet Muhammad (s.a.w) asked a Bedouin who had left his camel untied, “Why do not tie your camel?” the Bedouin answered, “I put my trust in Allah” the Prophet then said, “Tie up your camel first then put your trust in Allah” (Tirmidhi)


From these two evidences, we can conclude that Islam not only encourages Muslims to help each other and do charity but also to manage their risks. Thus, modern Takaful was born from the applications of these two concepts. The most common form of takaful in the market currently are two; Mudarabah and Wakalah contracts. In the Mudarabah contract the takaful operator establishes an investment partnership with the takaful policyholders and works as their mudarib (operator) to manage the investment. In the second model, the takaful policyholders are the owner of the pooled fund and appoint a takaful operator as a wakil (representative) to manage their fund at a fee. In short, the working principle of takaful is not far off from the principle of mutual funds, which we will discuss further, in subsequent chapters. Although it seems that Muslims have been very receptive and supportive of the application of risk management via takaful, there are still issues and challenges about it, whether from the viewpoints of Shari‟ah or financial. Therefore, in this study we attempt to identify and discuss the issues of the existing practice of takaful in the market.

For the ease of reading, this paper will be organized into five (5) chapters. The first chapter is the introduction and background of takaful. The second chapter is the literature review where we will summarize some articles and literatures produced by others on takaful or Islamic risk management. The third one will discuss on the type and structure of existing takaful in the market. Next, we will move to the main body of this paper discussing the point that we have identified as Shari‟ah and financial issues of takaful. And last but not least, is our conclusions and recommendations out of this study.




There is a lot of literature focusing on risk management, takaful and objectives Shari‟ah. Most of the articles discuss and analyse either all of the aforementioned topics separately emphasizing on a particular issue pertaining major topic, either they talk about risk management in takaful, or risk management and Maqasid al-Shari‟ah or takaful and objectives Shari‟ah. For proper literature review, we categorize the literature into the following themes:

risk and risk management,

takaful and insurance

takaful and Maqasid al-Shari‟ah,

takaful, risk and risk management,


Papers pertaining aforementioned topic such as “Risk Management: An analysis of issues in

Islamic Financial Industry” (Khan & Ahmed, 2001), “Risk Management and Mitigation Techniques in Islamic Finance A conceptual framework” (Kumaran, 2012) and “Risks in Islamic banks: description and analysis” (Meshaal, 2013) provide overview of risks and risk management in Islamic financial industry, most fully emphasizing on Islamic banks only. “Enterprise Risk Management (ERM) Practices Among Government-Linked Companies (GLCs) in Malaysia” (Yazid, Wan Daud, & Hussin, 2008) discusses relatively new phenomenon of ERM. Again, all of these articles do not mention takaful at all or mention only in passing.


First of all, there are reports about takaful industry. “International Takaful Report 2012-2013:

Shari‟ah and Legal Analysis” (Khan & Hasan, 2013) presents takaful from Shari‟ah and legal regulatory considerations in the Gulf Cooperation Council countries. “The World Takaful Report” (A MEGA Brand, 2012) and “Takaful Review” (A.M.Best, 2011) provide


global report of Islamic insurance industry, showing financial strengths of the companies as well as discussing issues pertaining industry. Books such as “Essential Guide to Takaful (Islamic Insurance)” (Engku Ali, Odierno, & Ismail, 2008), “Takaful and Retakaful:

Advanced Principles and Practices” (Frenz & Soualhi, 2010), “Insurance and Takaful(Salleh, 2010), “Fundamentals of Takaful(Yusof, Wan Ismail, & Abdullah, 2011) generally review takaful, also the subjects related to Islamic insurance starting with explanation of Islam, Islamic finance and Islamic financial contracts; covering such topics as takaful operations and models, markets, retakaful as well as risks in takaful. However, they are silent on objectives of Shari‟ah topic. “Islamic Financial System: Principles & Operations” (ISRA, 2012), in its turn, provide overview of Islamic finance and its operations, taking into account all the main topics regarding it as well as risk management, takaful and objectives Shari‟ah.

However, these topics are discussed separately and in general manner. “The Concept and Challenges of Takaful Investment in Malaysia(Abdullah, Laldin, Ali, Ahmad, Abdullah, & Zuki, 2013) and “A Shari‟ah Compliance Review On Investment Linked Takaful In Malaysia” (Noor, 2009) articles discuss mainly issues regarding investment activities of Islamic insurance companies in Malaysia. Other articles such as “Problems and Prospects of Islamic Banking: a case Study of Takaful(Ahmad, Masood, & Khan, 2010), “Takaful: An Innovative Approach To Insurance And Islamic Finance” (Masud, 2011), “Islamic Insurance and Reinsurance: Theory and Practice” (Mulhim & Sabbagh), “Takaful Models and Global Practices” (Akhter, 2010b) and “The concept of takaful(DarAlTakaful, 2013) have a broader coverage, but again it is general review of and retakaful without referring to risk management and objectives of Shari‟ah. “Insurance Solvency Supervision, European Regulation And Takaful Products” (Dreassi, 2009) and “Solvency of Takāful Fund: A Case of Subordinated Qard(Onagun, 2010) talk about solvency of Islamic insurance companies.


Fulfilment of Maqasid al-Shari‟ah via Takaful(Abdul Aziz & Mohamad, 2013) and Takaful From A Maqasid Al-Shari‟ah Perspective” (Abdullah S. , 2012b) are one of the rare articles discussing takaful and Maqasid al-Shari‟ah. However, all discussion concludes that Islamic insurance concept is in line with Maqasid al-Shari‟ah, without referring to the techniques of risk management in and them being in line with Shari‟ah objectives.




“The Parameter Of Permissible Risks In Takaful(Ahmad & Hashim, 2011), “Risk Management in Takāful” (Akhter, 2010a), “Risk and Risk Management of Takaful Industry” (Aris, Tapsir, & Abu Talib, 2012), “Takaful and Mutual Insurance: Alternative Approaches to Managing Risks” (Gönülal, 2013) and “Risk management efficiency of conventional life insurers and Takaful operators” (Yusop, Radam, Ismail, & Yakob, 2011) cover risk and risk management aspect of takaful industry. Although these articles and books analyse methods and techniques of risk management in Islamic insurance industry as well as the efficiency of the companies unlike the articles from previous section they are silent about Maqasid al- Shari‟ah. It is obvious from literature review that there is no literature that discusses all three aspects, namely risk management, takaful and objectives Shari‟ah together, except “Risk Management via Takaful from a Perspective of Maqasid of Shari‟ah(Abdullah S. , 2012a). Nonetheless, even this article just shows that risk management is a concept that lies within the spirit of Shari‟ah in general and in takaful in particular. Therefore there is a gap in research, which this paper will cover. To be more precise, there is no literature that discusses aspects of risk management in takaful from Shari‟ah objectives perspective, in other words are the techniques and concepts used by takaful operators in harmony with the concept of objectives of Shari‟ah?




There are two major model of takaful currently in practice in the market, Mudarabah & Wakalah.

  • 3.1 Mudarabah Model

Mudarabah originates in Malaysia, first by Syarikat Takaful Malaysia (STM) in 1984. In short, the policyholder and the shareholder operate on a joint venture basis. Both the policyholder and the shareholder share the direct investment income, in term of percentage. The policies separate a proportion of the premiums paid into tabarru‟ (donation) account for the risk coverage and the investment account. The tabarru‟ account generally under the jurisdiction of the shareholder. The sum assured depends on the amount of the tabarru‟ account, and the performance of the investment fund. The shareholder only shares in the investment return, to incentivize them to search for better investment opportunity. In the event of a loss, the shareholder has to top up the fun. The mudarabah contract is cancellable, and upon cancellation, all cumulative capital plus profit must be returned to the capital provider less administrative expenses. Consent must be granted by the policyholder to the shareholder for investing on the Shari‟ah compliant instruments.

Many Shari‟ah scholars have concern on the risk contract in which the underwriting surplus being treated as mudarabah profits. Contribution to the tabarrufund is considered as a one- way transaction in which the contributor has no right to take any benefits from it. Tabarru‟ fund is reserved for any participants who face financial difficulties or losses within the time period in the insurance policy. There are a few concerns from Shari‟ah perspective on this practice:

  • 1. There is concern that effectively the policyholder contributes their premium directly to the shareholder because it is the shareholder who controls the usage of the fund.

  • 2. Technically the contributions in tabarru‟ (donation) and it is not mudarabah (profit sharing). Thus the takaful should not be called mudarabah contract since a portion of it is donation.



3. In mudarabah contract generally, distribution of profit is via investment profit. This profit is not

In mudarabah contract generally, distribution of profit is via investment profit. This profit is not the same as surplus (excess of premiums over claims, reserves, and expenses)

3. In mudarabah contract generally, distribution of profit is via investment profit. This profit is not
3. In mudarabah contract generally, distribution of profit is via investment profit. This profit is not
  • 4. The practice of top-up interest free capital which is called qard al-hasan is not in line with the mudarabah concept.

  • 3.2 Wakalah Model

This model is commonly applied in gulf countries. Wakalah is a contract of agency. Basically the policyholder appoints a company owned by shareholders to manage his affairs. In takaful operation, the shareholders are appointed as a representative by the policyholders, to manage the takaful fund for a defined fee. Under this model, the ownership of the takaful fund remains with the policyholder. The shareholders, will deduct the fund from its operating expenses which include the management fee, claim reserves, technical reserves, retakaful etc. The balance or normally known as underwriting surplus, will be used for investments and distributions among the policyholders. There are a few concerns from Shari‟ah perspective on this practice

  • 1. Same with mudarabah, in wakalah model, a percentage share of the underwriting surplus is paid as a performance incentive for the operator. This might lead to taking advantage of the lack of information from policyholder perspective to mislead them to pay a higher premium in return of lesser coverage & benefits.

  • 2. In a typical wakalah, tabarru (donation) remains under the property of the policyholder. This might be giving problems and issues such as inheritance and zakat in which it is not possible to calculate the share of the surplus in the pool at time of death.

  • 3. Another generational issue is the compulsory qard al-hasan for the shareholder in the case of deficit in the Tabarru fund. This contribution supposed to be returned by the future generations, but the future generations are not the one who has given rise to the deficit.



Mutual Insurance & Takaful

Mutual insurance is the oldest from of insurance that still exists until today. According to Wikipedia, a mutual insurance company is an insurance company owned entirely by its policyholder. Any profit earned by a mutual insurance company is rebated to policyholders

in the form of dividend distributions or reduced future premiums. Mutual Insurance Company operates by the principle that the monetary loss per member is smaller, the larger the company is. In other words, mutual insurance is a not for profitcompany in which collects monthly premium in exchange for protection against risk for all its members. It target is not making money, but rather service and affordability were the main concerns.

The best way to explain mutual insurance is by looking at the real life example. One of the best-run mutual insurance companies is Folksam in Sweeden. As its website puts it, Folksam is a mutual company, meaning our customers are also our owners. The profit doesn‟t go to shareholders, it stays within the company and benefits us all … Our vision [is] that People should feel secure in a sustainable world.” Folksam was founded in 1908, in its own words, as “a response to great injustices”—the inability of ordinary people on low incomes to be able to obtain the sort of insurance protection relevant for them. Until today, it is closely connected to the cooperative and trade union organizations in Sweden. Rather than just concentrating on insurance, Folksam has also taken a few significant initiatives that are very successful in bettering the life of its policyholders. For example, they have put effort in the last 30 years to reduce the number of road accidents by investing in road safety research. The date that they have collected also enable Folksam to identify most safe and environmentally friendly car, and they use this data to give incentive in term of lower insurance premiums for the car owners. Besides road safety, Folksam also takes initiatives in various fields such as engagement with the companies whose share it holds to influence the companies to do ethical business and reduce environment unfriendly activities. They also push for gender equality remuneration policies and equal presence on the board level.

Takaful was conceived in the late 1970s out of the need for Islamic banks to have insurance coverage consistent with Muslim principles. According to Wikipedia, takaful is a co- operative system of reimbursement in case of loss, paid to people and companies concerned about hazards, compensated out of a fund to which they agree to donate small regular contributions managed on behalf by a Takaful operator. By its definition, Takaful should be


run like a mutual insurance in which its main objective is the security and benefits to its members. But in its current structure and manifestation, Takaful operators run takaful for profits and its objective is to provide a good return of investment to its shareholders.

This situation arises because of several factors. In the today world, the minimum size requirements and regulations in minimum capital for insurance-based company including takaful requires takaful companies to seek investors to provide for the initial funds. These investors surely require return for the capital that they have putted in. It would be almost impossible for a truly mutual insurance to be set up with the current requirements and regulations still in place. Also sometimes difference interpretation of sharia law and the lack of global standards at how sharia applies to takaful resulting in the difference of practices between jurisdictions. For example, sharia scholars may differ in opinion on the following:

  • 1. Whether the takaful shareholders are entitled to a share of any underwriting profits

  • 2. How any surplus on a winding up of a takaful fund(s) should be allocated

  • 3. Whether the tabarru‟ (risk premiums) should be paid into a waqf (trust fund)

Thus it is very hard to agree on the most rightful implementation of takaful in the modern times. Thus we believe that the most easiest way out for takaful operators is to follow mostly the conventional way of running insurance with a few exceptions to ensure Shari‟ah compliance. This will surely implies that takaful will be closer to stock insurance rather than mutual.




  • 4.1 Principal-Agent Issue

In economics theory and real life situation, agents will try to maximize their fee income. In the current wakalah structure, income is defined as a percentage of premium income collected. In such case, it is arguable that agent will be incentivize to increase turnover through poor underwritings and improper premiums. This might lead to insufficient portion of the contribution to the claim in the situation of a crisis or bad situation, for example when a major disaster like tsunami and typhoon affects a majority of the policyholders. Furthermore, the agent or the operator in such bad situation in which the fund allocated for claim is insufficient; is not liable to provide the extra fund for the claim. This is also true for mudarabah based takaful.

Operator of takaful in the current structure also has a share in the profit of surplus, but not in the loss. Normally surplus is invested in Shari‟ah compliance investment products. Without proper control, the operator will be has an incentive to invest in a high return, high-risk investment. In a bear market condition, this investment might turn out to be bad and depleted the policyholder fund. But then also, the operator will not be penalized for this. In term of Shari‟ah community is also divided; some sees it as contrary to the concept of mutuality. It is also not fully in accordance to the wakalah or agency contract in which the agent is entitle to a predetermined & quantifiable fee. Some scholars see it as permissible as an incentive for good performances.

Another difference between mutual the takaful is that in mutual, it is expected that the focus is on customer service rather than profits alone. In an agent-principal relationship such in takaful, the operator as the agent may seek to maximize profit by minimizing expenses, which inadvertently can affect service to the policyholders.

The fees structure also favors operator since the participants has no say, other than comparing with a few operators. Surplus distribution also determined by the operators. This is not easily monitored, thus corporate governance is an important issues in takaful. The surplus is also has to be invested in a proper way in a Shari‟ah compliance companies. This is supposed to


be advised and monitored by a Shari‟ah board. However, sharia scholars are rarely versed in the technicalities of insurance, and some decisions that they made is arguable.

For example, one disagreement is in the application of tabarru‟, which literally means ("to donate, contribute, or give away"). According to Wikipedia, tabarru‟ means participant agrees to relinquish a certain proportion of his takaful installments that he agrees or

undertakes to pay, should any of his fellow participants suffer a defined loss. The issue relates to the finality of donations: specifically, once an amount has been donated, the donor loses all rights to the donation. This is the principal reason why participants in takaful do not have equity in the risk pool, unlike policyholders of mutual insurers. When a surplus transpires, the participants will not a refund of part of their contributions because they have given up their equity.

  • 4.2 The Driver of Takaful Operator: Profit

The main objective of takaful is to share risks among participants and it is one of the available ways of managing risk. Indeed, the word Takaful originates from the Arabic word of Kafalah which means “guaranteeing each other” or “joint guarantee”. The purpose of this concept is not to generate profit but to uphold the principle of “bear ye one another‟s burden1 or to help each others. However, how far does the contemporary takaful activity really meet the main objective? Similar to Islamic banking system, in their early days, from providing alternatives for banking activities for Muslims, has switch to quest for profits. Indeed, in takaful business, there will be surplus in terms of investment and underwriting. As sharing the investment surplus or profits between participants and takaful operators is a non- issue, the sharing of underwriting surplus is debatable. It is acceptable in Malaysia to share underwriting surplus, however, it is considered unacceptable in Islamic point of view in the other part of the world. In the previous era, takaful operators were first developed in the Middle East, out of the desire of banks to obtain insurance that are in accordance to Shari‟ah law.

As profit was not a prime consideration, takaful operators were set up on pure cooperative principles. All surpluses remained in the fund, and actual expenses were charged to the risk fund. Profit for the operator was purely on investment income generated by capital. On the

1 Galatians 6:2 (King James Version)


other hand, the first takaful operator in Malaysia (Syarikat Takaful Malaysia) was established in 1984 to support the operations of the owner that is Bank Islam Malaysia 2 . In the beginning, Syarikat Takaful Malaysia used a mudarabah model for its family takaful (life insurance) operations, in which the operator and the participants shared the profit from investments of capital (operator only) or policyholder funds (operator and participants). Management expenses were paid out of the profits shared with the operator. Then, as general takaful and yearly group takaful developed, underwriting surplus was also shared. This was a practical consideration, as investment income for such plans was insufficient to cover expenses, and thus surplus was treated as “profit” under the mudarabah model. The distribution of underwriting surplus under Mudarabah model has brought the criticisms from Shari‟ah scholars. Mudarabah model is an equity contract in which the profit will be distributed proportionately while the loss will be born solely by the capital provider. The most important part is that, the remaining principal capital, both under profitable or losing conditions, must be return back to the capital provider. Please refer the diagram below to have a clear flow of how takaful operates on Mudarabah concept:

Family Takaful based on Mudarabah concept

Taawuni Account Participant’s Personal Investment Account Expense Fund Surplus Personal Risk Investment administrat ion charge Risk
Taawuni Account
Personal Investment
Expense Fund
Personal Risk Investment
ion charge
Risk Fund
t Income
Special Fund
If risk fund is
Investment Fund

*source : Takaful Ikhlas

According to the diagram above, participant is the capital provider while the Takaful operator is the trustee. Based on the model, the Takaful contribution made by a participant will go to Taawuni Account Pool and Investment Account. If there is any surplus out of Taawuni

2 Malaysian Takaful Industry 1984-2004, Bank Negara Malaysia


Account Pool, it will be credited as surplus. Later, the surplus, either profitable or not, will be

distributed between the participant account and the operator. The operator‟s portion is called

SAC (Surplus Administration Charge). The issue here is about the definition of the surplus. Under mudarabah contract, surplus should be profit, and not the principal. Thus, the operator is entitled for the profit but not the remaining principal. The current practice is that, the surplus is anything left after the total risk fund is deducted with claims, and it includes the balance principal. Admittedly that the basis for takaful, clarified by the Islamic Fiqh Academy, emanating from a meeting of the Organization of the Islamic Conference in Jeddah in December 1985, resolved that there are three main principals to be met for takaful operators to be considered Islamic, which are:


In accordance to Shari‟ah ruling


Charitable Donation (tabarru‟)


Cooperative principles

The discussion did not mention about whether any underwriting surplus can be shared between the participant and the operator or whether it should be distributed solely to the participants or be used for some other purpose, that is, as reserves or charitable donations 3 . However, as mentioned before, the definition of surplus in mudarabah is the profit not the principal. Thus, takaful operators could operate based on other concepts such as wakalah- jua‟lah model, which possess lesser Shari‟ah-compliance risk. Under wakalah-jua‟lah model, a Takaful operator is entitled for a wakalah fee (i.e. Expense Fund) and later also entitled for jua‟lah fee if there is any surplus. jua‟lah is a fee imposed on performance basis. Nonetheless, whichever model is used, generally, in contemporary Islamic finance environment, takaful operations has been slightly slipped from its initial objective that is to help each other against possible losses.

We are of the view that profit seeking is not immoral; however, it can be so if profit was to be the main goal. The markets for takaful are growing and interest continues to grow mainly in line with the development of Islamic banking in many Muslim-majority countries and Muslim-minority countries. The growing interests is surely attractive for profit-seekers, and in some markets, competition has been aggressive with respect to fees, charges, and profits. The takaful operator sets up a takaful fund, which is put together for groups of participants to

3 Taylor, Dawood. n.d. “To Be or Not to Be (Takaful), That Is the Question.”


assist each other in times of need. The direct link between contributors and those in need is not present. There is less focus on religion and religious observance, although a sharia council carefully reviews the practices of these firms to ensure compliance. Therefore, takaful can be considered a mutual insurance hybrid, operating in a new segment of the universe of insurance models. Takaful is similar in structure to a mutual insurance company, which is run by a stock insurer for a fixed fee, but also to a faith-based insurance company, which needs to comply with religious principles 4 .

  • 4.3 Underwriting and Liability Risk Issue

The liability risk could be lower than for conventional insurance if the takaful operator stays away from providing contribution guarantees, especially for long term family takaful business. On the other hand, operators are faced with a potentially more volatile and less diversified portfolio in view of the small market place. However, this could easily be managed through an appropriate retakaful arrangement. Strong competition, together with lower economies of scale and lower investment returns, could result in mispricing or under- pricing and premium insufficiency. The lack of clams experience data poses a challenge when it comes to establishing loss reserves. In the absence of credible experience data, more conservative assumptions need to be used for reserving (Frenz & Soualhi, 2010).

Moreover, takaful operators having Shari‟ah Supervisory Board have higher financial expenses comparing to conventional counterparts, which do not need this board. Eventually, Shari‟ah compliance together with the salaries of Shari‟ah Supervisory Board reduces the income of takaful operators. The takaful operator as an investor faces a challenge in matching assets to liabilities. Though long-term investment is potentially more profitable than short- term investment, the takaful operator has to maintain a sufficient amount of liquid assets in the takaful funds to be able to pay out arising claims. The problem with fully liquid assets is that they are not invested and, therefore, do not earn profits. Conventional insurance companies have access to a wider array of highly liquid assets, such as bonds, that can be sold on short notice in the secondary market. Malaysian takaful companies have access to a fairly well developed sukuk market, which allows them similar facilities, but takaful

4 Hybrid Insurance Structures: Reciprocals, Hybrid Mutual Insurers and Takaful Zainal Abidin, Hassan Scott, Sabbir Patel.


companies outside Malaysia are handicapped in this regard (Abdullah, Laldin, Ali, Ahmad, Abdullah, & Zuki, 2013).

“The Guidelines on Takāful Operational Framework” (BNM, 2012a) emphasizes that takaful

operators must formulate policies for prudent fund management in order to avoid any adverse impact. To do so, they need to take into account the amounts and timings of the takaful liabilities and, based on that, choose investments commensurate with the particular fund‟s

tolerance of risks (BNM, 2012a). Having realized the importance of proper asset-liability management in a financial institution, the study views this duty as very challenging to the takaful operator. It not only needs to manage the shareholders‟ fund, but also the takaful fund, a separate entity from the company‟s fund. Therefore, the takaful operator must ensure transparent reporting in the asset and liability management that ensures segregation of the two funds.

  • 4.4 Operational Risk Issue

Operational risk is all risks other than market, credit and underwriting risks. With takaful being at a young stage, it is naturally subject to higher operational risks for various reasons:

Evolving takaful regulations and accounting standards resulting in uncertainty and potentially additional compliance costs, e.g. changes expected in:


valuation requirements and RBC,


regulations detailing how to ensure intergenerational equity in surplus


sharing, which is currently at the discretion of the operator or appointed actuary, and potential conflicts due to dual supervision by both regulator and Shari‟ah board.

Potential mismanagement:

Conflict between Shari‟ah compliance and professional risk management might result in sacrificing one for the other. Lack of takaful professionals and Shari‟ah scholars is a natural source of mismanagement. In dual markets, there is fierce competition with conventional insurers for market share. However, takaful operators are often less well capitalised, and enjoy lower economies of scale and potentially lower investment returns. This could result in;






under-pricing or expense overrun;


failure to adhere to underwriting and claims guidelines for the sake of

increasing the top line. Risk of mis-selling:


Although transparency is an objective of takaful, it is often lacking in takaful contracts, There is also a general lack of takaful understanding amongst agents and the public. The perception is often that takaful is the same as insurance, which is clearly not the case.

As mentioned above, IT framework used by Islamic insurance companies is still the same that used by conventional insurers. It calls to develop own IT framework, which will take into account features pertaining takaful business (Frenz & Soualhi, 2010). Not only that, the lack of any control mechanism for the funds invested by the fund manager. This is due to the fact that most of the investment activities are assigned to an external fund manager whose activities are governed by the operator‟s outsourcing service policies. To date, there is no standardized parameter regulating the policy, except a general provision in the “BNM Shari‟ah Standard on Mudarabah”, which gives an option to the mudarib to assign the capital under his management to another mudarib or another manager (as agent), subject to the conditions agreed to by the capital provider (BNM, 2012b).

Among the most important duties of the fund manager appointed as a sub-investment manager is to stay updated on the Shari‟ah compliant investment avenues, particularly securities, which are continuously reviewed by the respective authorities such as the Securities Commission. The proper and continuous mechanism of control is important to ensure that all funds are invested in a Shari‟ah compliant manner and Shari‟ah compliant instruments. The issue becomes potentially critical in a subsidiary structure where the investment duties are outsourced to the parent or to other companies in the same group or to a third-party fund manager against an agreed fee. The shared-service practice or outsourcing will result in a Shari‟ah non-compliance issue if the outsourced investment activities involve non-permissible investment avenues. This study is of the view that the outsourcing service policy adopted by the operators with their fund managers must clearly spell out the nature of the contract between them, either mudarabah (al-mudarib yudarib, i.e., a sub-investment manager), or wakalah (investment agent), or ijarah „ala al-„amal (a hire of service) and their


respective rights and obligations as reflected by the unique principles of the defined contract (Abdullah, Laldin, Ali, Ahmad, Abdullah, & Zuki, 2013).

The outsourcing service agreement should also clearly define the method of fee calculation, which must be consistent with the type of contract adopted. The outsourcer (takaful company) should also have ways to review and examine the investment undertaken by the subcontractor (fund manager) so as to ensure that such activities do not involve prohibited transactions which may taint the company‟s halal income. The takaful operator can provide the requirements on the screening, purification and remedial processes in the outsourcing policy and the agreement with the fund manager. In addition to the Risk Fund surplus, prudent management of the Investment Fund in a way that accumulates profits is another indicator of a solvent takaful operator. The issue, which needs serious investigation is how surplus and profit are each defined in the surplus and profit management policy and, consequently, how they are recorded in the financial report.

A close scrutiny of the internal surplus and profit management policy in various takaful operators may reveal that, in many instances, the two are referred to as the same item and the terms are used interchangeably. While „profit‟ may also be referred to, linguistically, as a „surplus‟, in the context of takaful, each results from a different fund, and they may be managed under different contracts that impose different rights and liabilities upon the takaful operator as the party managing the funds. As such, the financial report should separately disclose the profit from the Investment Fund (PIF) and the underwriting surplus from the Risk Fund (PRF) in detail before the Shari‟ah committee and the board for their further deliberation. Even if the Risk Fund is invested, its profit portion must be separately reported from that of the Investment Fund. Therefore, constant Shari‟ah review of the Surplus and Profit Management Policy and the Annual Financial Report must be carried out to ensure continuous standardization and transparency in the takaful operator‟s reporting.




The takaful industry, with its rapidly evolving landscape, is currently facing numerous regulatory and technical challenges. The industry is constantly seeking improvements in its effort to improve competitiveness and to meet Shari‟ah requirements as well as treating policyholders and takaful operators fairly, which is in line with Maqasid al-Shari„ah. It must also survive side-by-side with the conventional insurance industry. The lack of suitable human resources means that actuaries can add significant value to assist takaful operators in tackling these current issues faced by the industry.

Mutuality or cooperative is a concept that has existed for centuries in the insurance world. Actuarial expertise and knowledge in the management of mutual insurance business can be adopted within takaful to enhance its success. The takaful industry is continuously striving to develop best practices in the management and valuation of the business. Actuarial principles and practices in the conventional insurance context such as embedded value calculations, asset liability management, enterprise risk management, capital management, surplus determination, and distribution methodologies have direct application to the takaful industry, sometimes compromising Maqasid al-Shari‟ah. In addition to technical challenges, there are also regulatory challenges within the industry. Due to the varying degrees of Shari‟ah interpretation, there are difficulties in developing global takaful standards or regulations, although the IFSB has issued takaful consultation papers in an attempt to achieve some consistency in the industry. Actuaries can work closely with the regulators to develop a framework that is appropriate and relevant to takaful. With the conventional insurance industry moving towards a risk-based capital assessment regime, and with the current changes in the global accounting standards, considerations need to be given to their application to takaful.

The problems of development of new prospects of Islamic finance at the conceptual and practical levels still exist. There are three main points that should be kept in mind to develop Islamic finance: formal issues related to appropriate products and instruments to serve the goals, the human capital involved in the industry and the systemic matters of concept, paradigm, goals, structure and directions of an Islamic financial system. Obviously, substantial works should be employed not only in the foundational area of takaful but also in


the operational area. As a result, takaful will be able to provide genuine Islamic alternatives to contemporary insurance practices. For this purpose, a clear and coherent philosophical foundation that originates from an Islamic worldview is required. The study is limited to general overview, in other words the paper describes concepts and practices in general without going deep into details. Still, there are more researches can be done in the future covering each aspect of risk management in takaful from both theoretical and practical aspects. This, however, calls for closer collaboration of academicians with the industry, which merely was achieved during this research, because of lack of willingness of the people from industry to help the research.



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