Efficiency, Firm-Specific and Corporate Governance Factors of The Takaful Insurance

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Efficiency, firm-specific and corporate governance factors of the Takaful

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Article in International Journal of Islamic and Middle Eastern Finance and Management · June 2019
DOI: 10.1108/IMEFM-06-2018-0187
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International Journal of Islamic and Middle Eastern Finance and
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Efficiency, firm-specific and corporate governance factors of the Takaful
insurance
Hui Shan Lee, Fan Fah Cheng, Wai Mun Har, Annuar Md Nassir, Nazrul Hisyam Ab Razak,
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Efficiency, firm-specific and Corporate

governance
corporate governance factors factors
of the Takaful insurance

Hui Shan Lee
Department of Economics,
Universiti Tunku Abdul Rahman Faculty of Accountancy and Management, Received 6 June 2018
Revised 7 February 2019
Kajang, Selangor, Malaysia and Faculty of Economics and Management, Accepted 8 April 2019
University Putra Malaysia, Serdang, Selangor, Malaysia
Fan Fah Cheng

University Putra Malaysia, Serdang, Selangor, Malaysia
Wai Mun Har
Department of Economics,
Universiti Tunku Abdul Rahman Faculty of Accountancy and Management,
Kajang, Selangor, Malaysia
Annuar Md Nassir
School of Economics and Management, Xiamen University Malaysia,
Bandar Sunsuria, Sepang, Selangor, Malaysia, and
Nazrul Hisyam Ab Razak
Faculty of Economics and Management, University Putra Malaysia,
Serdang, Selangor, Malaysia
Abstract
Purpose – Malaysia is recognised as an emerging country with a large Muslim population, making the
Malaysian Takaful industry the largest Takaful market in the Southeast Asia region and, notably, one of the
fastest growing markets globally. Malaysia is also the first country globally to implement a risk-based capital
framework for Takaful. Therefore, the purpose of this paper is to identify the factors that influence the
efficiency level (cost efficiency and technical efficiency) of the Takaful industry and to examine the effects of
Takaful insurance firms’ specific factors and corporate governance factors that influence the efficiency of
Takaful insurance in Malaysia.
Design/methodology/approach – In this paper, the efficiency level of the Malaysian Takaful industry
was examined between 2011 and 2015. The sample consisted of 11 family Takaful and 8 general Takaful
operators. Two-stage Data Envelopment Analysis (DEA) was used by first, conducting non-parametric
frontier data envelopment analysis to obtain a DEA score for each operator. This was followed by panel
regression with the DEA scores as the dependent variable and the insurance firms’ specific factors and
corporate governance factors as the independent variables.
Findings – The results of DEA indicate that Takaful operators in general have allocative inefficiency but
family Takaful is more cost efficient than general Takaful. Results of panel data analysis reveal that corporate
governance factors do influence the cost efficiency but find no evidence on the firm-specific factors towards International Journal of Islamic
and Middle Eastern Finance and
the cost efficiency and technical efficiency on Takaful operators. Board size and the proportion of non- Management
executive directors impose a negative and significant relationship with cost efficiency, while proportion of © Emerald Publishing Limited
1753-8394
Muslim directors in the board is not significant. DOI 10.1108/IMEFM-06-2018-0187
IMEFM Research limitations/implications – This paper focused solely on Malaysia which uses strict
regulations governing the Takaful insurance market. Due diligence was also performed to minimise any
limitation in the paper. It is proposed that future studies should examine this issue in greater detail by
incorporating more data from other Muslim countries.
Practical implications – The findings of this paper have significant implications for policymakers to
understand the efficiency condition in the Takaful market. Takaful operators should maintain a small board
size with a higher proportion of executive directors, given they could improve the level of effective decision-
making to enhance the cost efficiency. As corporate governance factors are significant, Takaful operators in
Malaysia should also undertake transparent disclosure practice and reporting such as providing adequate
and relevant information related to Shariah compliance and principles to provide a robust foundation as the
Takaful market leader regarding Takaful regulations globally.
Social implications – The consumer is able to make a better decision when choosing Takaful insurance
company to protect their interests.
Originality/value – No similar paper has been undertaken to the best of the researcher’s knowledge using
similar research design and scope to investigate the efficiency of Takaful insurance as in this paper. Takaful
insurance is a rapidly growing industry in Malaysia, setting a prime example to other countries globally.
Malaysia was selected for this study, as it is the only nation that has implemented the most extreme
regulation in the Takaful insurance market.
Keywords Insurance, Corporate governance, Efficiency, DEA, Islamic financial institution
Paper type Research paper
1. Introduction
The insurance industry, inclusive of Islamic insurance, is a financial institution that
provides risk management services, produces liquidity, diversifies financial losses and
facilitates investment in an economy, as reported by Eling and Luhnen (2010a, 2010b); Fah
and Sin (2014), Biener et al. (2016), Shan et al. (2016) and Lee et al. (2018). Insurance is also
important in reducing potential credit crises that trigger potential banking disasters
(Acharya et al., 2013; He and Manela, 2016). Takaful (Islamic insurance) is the Shariah-
compliant alternative to conventional insurance that avoids prohibited concepts to conform
to Islamic jurisprudence, in which members distribute risks in each Takaful risk pool (Kader
et al., 2014; Khan et al., 2017). Takaful emphasises the requirement for transactions to be
supported by genuine (Halal) trade or business-related activities and governed by Islamic
finance law to set a higher standard for investments and to promote greater accountability
and risk mitigation. Recently, the global coverage of Islamic finance has integrated the
various financial systems of Muslim countries that serve to strengthen global financial
markets (Djaghballou et al., 2018; Khan et al., 2017; Nomran et al., 2018; Sufian and
Kamarudin, 2015). However, the importance of Takaful as a significant component of global
Islamic finance requires further focus and research on the Takaful industry in addressing
the key issues to achieve long-term growth (Gulf News, 2017). This paper examines cost
efficiency and the impacts of firm-specific factors and corporate governance factors on the
efficiency of Takaful insurance operators in Malaysia.
Takaful (Islamic insurance) is a concept in which a collection of contributors mutually
promise to compensate each other against any form of loss. Each contributor performs hihe/
sher responsibility by contributing a certain amount of money into a fund which is
administered by a third party, namely, the Takaful operator. If a loss is incurred, then the
Takaful operator pays out the funds accordingly to the victims. Once the commitment of
compensation to the contributors has been satisfied, the contributors share the surplus. In
this way, Takaful functions as security and a profit-sharing enterprise between the Takaful
operators and contributors (Al-Amri et al., 2012; Kader et al., 2014).
In Malaysia, the total assets of the Takaful industry for 2017 was RM29.3bn, an increase of Corporate
9.37 per cent compared to 2016 which was RM26.8bn. Family Takaful contributed 87 per cent governance
(RM25.6bn), while general Takaful contributed 13 per cent (RM3.65bn) to the total assets of the
factors
Takaful industry (Malaysian Takaful Association, 2018). Family Takaful has continued to
record encouraging growth in attracting new business, with new premiums increasing from
RM14.2bn in 2016 to RM15.1bn in 2017. Family takaful can generate profits in tandem with
overall growth in this market, which in 2017, recorded an excess income of RM18.8bn
compared to RM13.3bn in 2016. The key driver for this growth was related to investment-
linked products. However, general Takaful also faced a significant challenge in which its gross
business declined by 0.4 per cent because of contraction in the offshore oil industry.
Although general Takaful remained profitable in 2017 (operating profits at RM2.7bn), it
was less than the previous 5 years. In the Financial Stability and Payment Systems Report
in for 2017 issued by the Central Bank of Malaysia (Bank Negara Malaysia (BNM)), it was
anticipated that family Takaful would continue to show a gradual increase. BNM continues
to enhance the nation’s regulatory and governance initiatives towards preserving financial
stability and increasing the outreach of Takaful. The Bank has also identified the
importance of strengthening governance arrangements to oversee pricing practices and to
ensure the consistency of product development in line with company’s’ risk appetite and
financial strength. Hence, the improvement of corporate governance in the Takaful industry
will promote greater scrutiny by the board and senior management to ensure the suitability
of products for identified target markets.
Global insurers are interested in emerging markets, as they perceive this as a business
opportunity in which they can grow to become more prosperous (Jeng, 2015). Interestingly,
Malaysia as an emerging country with a large Muslim population makes the Malaysian
Takaful industry as one of the fastest-growing markets globally. The Global Takaful Report
(2017) identified Malaysia as the largest Takaful market in the South East Asia region in
2015, with a 62 per cent market share, followed by Indonesia at 33 per cent. Malaysia is
leading the Takaful industry regarding Takaful regulations, given it was the first country
globally to implement a risk-based capital framework for Takaful. Malaysia has also
accomplished significant landmarks in the expansion of its Takaful industry with the first
Takaful operation established in 1985.
Since then, Malaysia’s Takaful industry has been gaining momentum and has since become
identified as an important industry within Malaysia’s overall Islamic financial system.
However, the Takaful industry in Malaysia has encountered structural reformations that have
significantly affected overall sustainability. These reformations have highlighted the
importance of cost controls through minimising inefficiency in insurers’ operations. Nomran
et al. (2018) argue that Malaysia is the only country in the Muslim region that has implemented
the most rigorous intervention of regulatory agencies. Therefore, an examination of the impacts
of corporate governance on the efficiency of Takaful operators in Malaysia will make a
significant contribution to the field of efficiency, corporate governance and Islamic insurance.
The ultimate choice of Takaful operators is driven by many factors such as the size of the
firms, provision for outstanding claims and international diversification by foreign
participation. Al-Amri et al. (2012) and the World Takaful Report (2016) suggest that if the
complex Takaful model is not entirely developed and tested, then Takaful operational
systems will perform poorly which might result in dissatisfaction amongst customers and
inefficiency of the Takaful business, leading to instability in Islamic finance. Thus, this
paper raises the question, “What are the firm-specific factors that impact the efficiency of
Takaful insurance?”
IMEFM Furthermore, a reliable and robust governance system could help to assist Takaful
operators to improve operational efficiencies (Huang et al., 2011; Kader et al., 2014).
According to agency theory, the entrustment of managerial responsibilities by owners
(principals) and managers (agents) involve the existence of a mechanism to monitor the
performance of managers and to ensure that they use their delegated authority to the best
interests of the principals. As the Takaful industry is also part of the global financial
system, examining the issues relating to the corporate governance mechanism to maintain
the investors’ confidence has become unavoidable. This is mainly because directors’
fiduciary responsibilities in Takaful operators are not only limited to shareholders and
policyholders, but they are also subject to oversight by the Shariah supervisory board of the
company and regulators (Nomran et al., 2018). Hence, the board composition of Takaful
operators is worth examining given the unique characteristics of the Takaful market.
The novelty of this article is that it uses data on Takaful (Islamic insurance) operators to
look for evidence on firm-specific factors and board composition issues on an efficiency
level. The findings demonstrate that the firm-specific factors do not have significant impacts
on efficiency; however, the board composition analysis in this study revealed significant
influences on the efficiency of Takaful operators. Our results also indicate that a larger
member size consisting of board directors and a higher number of non-executive directors
will result in cost inefficiencies of Takaful operators. The outcomes also suggest that a
larger board size consisting of directors will cause the risk of conflicting opinions and the
risk aversion of non-executive directors that might be induced by the uncertainty regarding
Shariah compliance. These situations are detrimental to business decision-making, causing
the inefficiency of Takaful operators. It is anticipated that the contribution of this paper will
help readers to understand the business function(s) of Islamic corporate finance and more
specifically to recognise this emergent sector of the insurance industry by studying the
economic efficiency of Takaful operators.
The remainder of the paper is organised in several sections. Section 2 provides an
overview of the efficiency in the insurance and Takaful industry which is followed by
hypotheses concerning efficiency. Section 3 presents the data and methodology followed by
Section 4 which discusses the results of the paper. Finally, Section 5 presents the conclusions
and main findings of this paper including implications for managers and policymakers.
2. Literature review
2.1 Modern business practice in the insurance industry
The insurance industry’s main principle is managing risk which is based on the concept of
collecting premiums founded upon how much risk policyholders contribute to insurance
firms (Arayssi, 2014, p. 1). The literature also reveals that insurance firms will withstand
their growth given the population continues to grow, people retire much younger and also
live longer. Thus, actuarial science could help to enhance the risk management process by
mitigating against adverse selection and performing a meticulous analysis. The main aim of
insurance firms is to achieve efficient insurance management.
2.2 Efficiency and data envelopment analysis

Efficiency is achieved by approximating “best practice” and studying other frontiers which
are efficient; comprising of dominant firms in a similar industry and comparing all firms in
the industry to frontier firms. Charnes et al. (1978) developed Data Envelopment Analysis
(DEA) to evaluate the efficiency activities of non-profit bodies’ participation in public
programs. Later, DEA was expanded to evaluate the efficiency level in financial industries
(Apergis and Polemis, 2016; Jaiyeoba et al., 2018; Sufian and Kamarudin, 2015). The
insurance industry continues to encounter many challenges, such as solvency risks, a Corporate
shifting regulatory environment and competition. Therefore, determining the efficiency of governance
the insurance industry is paramount in identifying how insurers will respond to these
challenges and through recognising the related input and output factors. Inefficiency and
factors
delays in claim settlement practices in insurance companies caused by escalating prices
prompted a study in 1993 by Cummins and Weiss to measure cost efficiency in the non-life
insurance field (Cummins and Weiss, 1993).
Later, Mahlberg and Url (2010); Cummins and Xie (2013) and Biener et al. (2017) used
DEA developed by Charnes et al. (1978) to examine the efficiency of insurance firms. This
method does not impose any functional form on the data, allowing the method to use
multiple inputs and outputs (Jaiyeoba et al., 2018). The results of these studies suggest that
firm size, ownership structure, mode of business and human capital are important factors
that affect firm performance. In our study, there are a total of three firm-specific factors that
will be examined; the size of Takaful operators, international diversification structure with
or without foreign participation and provision for outstanding claims.
Efficiency studies in the Takaful industry are limited given the majority of studies in this
area only existed after 2010. A study by Kader et al. (2010) investigated the cost efficiency of
non-life Takaful insurance firms in 10 Islamic countries between 2004 and 2006 and found
that board size, product specialisation and firm size have positive impacts on cost efficiency.
Moreover, cost efficiency is not influenced by the separate roles of the Chief Executive
Officer (CEO) and the Chairman. This study was later extended by Kader et al. (2014)’s
study that explored the relationship between cost efficiency and board composition in non-
life Takaful firms between 2004 and 2007 in 17 Islamic countries. The findings of their study
suggested that the levels of cost efficiency in Takaful firms were similar to the efficiency in
developed non-life insurance markets. Furthermore, they confirmed that the impacts of
board composition on efficiency rely on firm-specific factors. Our study also includes firm-
specific factors and corporate governance factors as independent variables towards the
efficiency of Takaful operators, given that the cost efficiency of Takaful operators could be
complicated by various firm-specific factors and corporate governance structures.
Recent investigative studies by Al-Amri et al. (2012) and Al-Amri (2015) focused on the
efficiency in Gulf Cooperation Council (GCC) countries. Here, their studies concentrated on
technical efficiency which is distinctly different from the studies by Kader et al. (2010) and
Kader et al. (2014) which focused on cost efficiency. A study by Al-Amri et al. (2012) found
that the Takaful industry in GCC is moderately efficient and suggests that improvement in
technical efficiency is needed. Also, the results illustrate that the Takaful sector in GCC is
experiencing high growth.
Later, Al-Amri (2015) suggested that the evaluation of efficiencies should cover technical,
purely technical, cost and allocative efficiencies as well as the identification of the main
sources of inefficiencies. Therefore, to understand the studies conducted in the Takaful
industry, this study examines both cost efficiency and technical efficiency by incorporating
firm-specific characteristics and corporate governance structures as factors influencing
inefficiencies.
In another study by Yakob et al. (2014), DEA was used to obtain the risk and investment
management efficiency score for conventional and Takaful insurers in Malaysia between
2003 and 2007. The firm-specific factors examined included operating systems,
organisational form, consumer preference and size. The findings of their study suggest that
Takaful operators perform risk management better compared to conventional insurers and
that larger firms show better risk management efficiency, whereas consumer preference is
not significant.
IMEFM On the other hand, consumer preference is positively influenced by investment
management efficiency. As this study is focusing on risk and investment management
efficiency on Takaful operators in Malaysia and also does not include the corporate
governance structure, we, therefore, attempt to close the gap by examining the relationship
between efficiency (cost and technical) with firm-specific factors and corporate governance
factors in the Malaysian Takaful industry.
2.3 Hypothesis development

Six hypotheses are developed in this study. The first three hypotheses cover the firm-
specific factors namely firm size (SIZE), international diversification with foreign
participation (FOREIGN) and provision for outstanding claims (PROVC). The factors for
corporate governance include the size of the board [of directors] (NOBOARD), the ratio of the
non-executives of the board [of directors] (RATIONE) and the ratio of Muslim directors of
the board [of directors] (RATIOMUSLIM).

2.3.1 Firm size. The majority of findings from previous studies have revealed that there
is a positive link between both size and efficiency (Eling and Luhnen, 2010b; Eling and
Schaper, 2017). Larger firms tend to be well diversified and are more prone to enjoy
economies of scale. Economies of scale exist when increases in output numbers lead to
average per unit output cost decreases which is because of the distribution of a firm’s fixed
production costs, for example, financial capital or the technology system over a higher
number of outputs. Similarly, learning effects obtained from managers operating at larger
firms was another form of the economies of scale. Notwithstanding, risk pooling was also
found to be more prominent and successful in large-scale Takaful operators where they were
able to minimise income volatility. Thus, the following hypothesis is:
H1a. With other factors being constant, the efficiency scores of Takaful operators are
positively related to the size of the Takaful operator.
However, Cummins and Xie (2013) argued that larger firms tend to have greater
management coordination and agency costs because of the complexity of administering
large and complex institutions. As a consequence, an alternative hypothesis is:
H1b. With other factors being constant, the efficiency scores of Takaful operators are
negatively related to the size of the Takaful operator.
2.3.2 International diversification with foreign participation. Given the Takaful market is
now opening for foreign participation, foreign firms are allowed to own a certain
percentage of the ownership of local Takaful operators. The entrance of foreign players
with huge capital and superior insurance market performance experience will assist
local Takaful operators to gain competitive advantage, thus improving their efficiency.
Access to new resources, additional innovative skills and average cost reduction are
examples of international diversification (Biener et al., 2016). In this sense, the following
hypothesis is:
positively related to the involvement of international diversification with foreign
participation.
Nevertheless, particularly for large foreign operators, the difficulties of foreign players to
comply with local rules and regulations, the complexity of management, cost of
synchronisation and cultural differences between local and the foreign markets (known as
the liability of foreignness) are treated as the main obstacles to international diversification, Corporate
hence, reducing the efficiency of Takaful operators (Jeng, 2015; Biener et al., 2016). governance
Therefore, the following alternative hypothesis is:
factors
reversely related to the involvement of international diversification with foreign
participation.
2.3.3 Provision for outstanding claims. The provision for outstanding claims was not found
in the literature, although this fund needs to be reserved. However, it is not the confirmed
capital to be spent. Cummins and Weiss (1993) mentioned that claim settlement practices
could cause inefficiency, whereas Zhang and Dukic (2013) and Spierdijk and Koning (2014)
suggested that insurers should respond to outstanding claims by setting aside this provision
which has consequently become a central subject in modern actuarial science. Arayssi (2014)
also highlighted that actuaries practise the law of large numbers to make the company’s
predictions more accurate to ensure the solvency of the insurance company by acquiring
adequate reserves. Estimating the provision for outstanding claims is a portion of the
reserves. As the provision for outstanding claims is part of the claim settlement process, it is,
therefore, reasonable to examine the impact of the provision for outstanding claims towards
the efficiency of Takaful operators. As insufficient provision could result in the default
of Takaful operators, a higher provision for outstanding claims might increase the efficiency
of Takaful operators. Hence, the following hypothesis is:
positively related to the provision for outstanding claims.
If too large a proportion of the provision for outstanding claims is reserved, then it will tighten
the operators’ funds and restrict other input expenses that are equally important in generating
an output; in this case, it will cause inefficiency. Thus, the alternative hypothesis is:
negatively related to the provision for outstanding claims.
2.3.4 Board size. The board of director’s responsibilities are to review the performance of all
management teams to ensure that the organisation follows the company’s objectives and
strategies to maximise shareholders’ wealth. The board members are required to provide
substantial resources and to establish a variety of skills in performing their duties (Hsu and
Petchsakulwong, 2010; Wu et al., 2016; Kuo et al., 2017). A large board can provide
additional expertise and competencies, better networks and increase compliance monitoring,
as well as having prudent monitoring to ensure reduction of financial fraud and inefficiency
(Hardwick et al., 2011). Therefore, the following hypothesis is:
positively related to the size of the board of directors.
On the other hand, Hsu and Petchsakulwong (2010) suggested that the costs of having a
larger board size might outweigh the benefits. Moreover, an oversized board may find it
more complicated to arrive at a consensus, thereby resulting in higher coordination
problems that impede the efficiency performance of insurers. Furthermore, the free-rider
problem has a higher inclination to arise in a firm with a larger board size that could de-
motivate the other board members. Thus, the alternative hypothesis is:
IMEFM H4b. With other factors being constant, the efficiency scores of Takaful operators are
negatively related to the size of the board of directors.
2.3.5 Proportion of non-executive directors on the board of directors. A study by Arayssi
et al. (2016) found that women who are represented on boards will result in the board providing
better governance. This complements the existing literature stakeholder theory, in which the
accomplishment of the company is formed by maintaining good relationships with its society.
Although we believe that non-executive directors as the board of directors are stakeholders that
respect the values of society, by responding to their societal concerns and obligations, Kader
et al. (2014) suggested that experienced non-executive (outside) directors are employed to advise
executive (inside) board members to ensure the alignment of contractual interests in firms. The
advice is related to strategic business issues as well as maximising efficiency. Additionally, to
establish the market value of non-executive directors’ as human capital, they are likely to have
stronger motivations to build the reputation of firms through their expertise in decision-
making. Thus, the following hypothesis is:
positively related to the proportion of non-executive directors on the board of
directors.
Similar to Kader et al. (2014), although we anticipate that non-executive directors provide
mitigation on managers’ self-interest incentives, there is a distinct possibility that the non-
executive directors of the Takaful operators encompass excessive prudence and risk
aversion that could be hazardous to effective business decision-making and, therefore,
reduce the efficiency scores. Therefore, the alternative hypothesis is:
reversely related to the proportion of non-executive directors on the board of
directors.
2.3.6 Proportion of Muslim directors on the board of directors. We believe that the existence
of Muslim members on the board can also have a substantial influence on the management
of Takaful operators given that the Takaful industry is growing because of the escalating
demand for an interest-free insurance system. The unique risks of Takaful operators is the
risk of Shariah non-compliance that can lead to fiduciary risk, legal risk and reputational
risks which ultimately can result in the risk of non-renewal of licenses and expose Takaful
operators to significant losses. Thus, the Muslim board of directors knowing Islamic finance
could help to prevent these risks from forming much better than non-Muslim members of
the board. Not the least, their decision-making related to Shariah-compliant issues can
translate into good performance and reducing inefficiency. For example, the importance and
value of the law of Islam (that complies with Islamic principles) in respect to Takaful
operators can be better understood by Muslim members compared to Non-Muslim members
(Ali and Azmi, 2016). Hence, the hypothesis is:
positively related to the proportion of Muslim directors on the board of directors.
However, it is worth mentioning that Non-Muslim members could have a better
understanding of Islamic finance compared to Muslim members given their educational
background related to Islamic finance. Hence, the alternative hypothesis is:
H6b. With other factors being constant, the efficiency scores of Takaful operators Corporate
are negatively related to the proportion of Muslim directors on the board of governance
directors.
factors
3. Data and methodology
This study examines a total of 11 family Takaful operators and 8 general Takaful operators
in Malaysia between 2011 and 2015. The firm-level data were collected from the annual
reports of Takaful operators.
To examine the factors that influence the efficiency of Takaful insurance in
Malaysia, this study conducted non-parametric frontier DEA in the first stage to obtain
a DEA score. Then, in the second stage, panel regression was used with the DEA score
as the dependent variable and the insurance firms’ specific factors and corporate
governance factors as the independent variables. The DEA approach with variable
returns to scale (VRS) was used to identify the input-oriented technical efficiency of
each Takaful operator.
This approach can also be explained through the use of decision-making units (DMUs)
(Sufian and Kamarudin, 2015). The final efficiency value is always positive and is less than
or equal to 1. If the objective value of the maximised score is close to 1, then the DMU is
interpreted as relatively efficient; otherwise, it is described as inefficient (Djaghballou et al.,
2018; Sufian and Kamarudin, 2015). Cost efficiency overall is composed of technical
efficiency (TE) and allocative efficiency (AE). TE means how technology is used efficiently
by the combination of inputs to accomplish a specified level of output. AE is used to
determine whether management chooses a mix of inputs provided with the information of
input prices at the efficient level. Thus:
CE ¼ TE * AE (1)
In this case, a firm has achieved full efficiency if the score is equal to 1. If the score is below
1, then it means that the firm has not achieved the full efficiency level as compared to the
reference firm that achieved an efficiency score of 1. The input variables, input prices and
output variables used in this study are explained in Table I.
In the second stage of panel regression, the equation used was panel linear
regression. The independent variables consisted of firm-specific factors and corporate
governance factors. Following the literature by Cummins and Xie (2013) and Biener
et al. (2017), the firm-specific factors were the firm size (SIZE), international diversification
with foreign participation (FOREIGN) and provision for outstanding claims (PROVC).
Initiated by Kader et al. (2014), the corporate governance factors were the size of the board of
directors (NOBOARD), the ratio of the non-executives on the board of directors (RATIONE)
and the ratio of Muslim directors on the board of directors (RATIOMUSLIM). As mentioned
previously, and as performed in this study, the impact of these factors was examined on both
cost efficiency and technical efficiency. This is because not all Takaful operators are prone to
have both cost and technical efficiency, as they may be unsuccessful in using the technology
input efficiently to achieve a given level of output. Thus, two equations are given as:
ln CEit ¼ lnSIZE þ FOREIGNit þ ln PROVCit þ NOBOARDit þ RATIONEit

þ RATIOMUSLIMit þ « (2)
IMEFM
Variable Proxy/explanation Price
Input
Labour =Management expenses þ Operating expenses =Average annual wage in
Malaysia
Debt capital =Government Islamic papers =Annual return of government
This is the amount invested in Islamic bonds investment issues (GII)
issued by the Malaysian government
Equity capital =Islamic securities and equities =Annual return of the Shariah
This is the amount invested in Islamic-related Emas Index
securities in the market
Output
Variable Proxy/Explanation
Net contribution =Net contribution income
income Takaful operators receive funds from their customers as a result of operating
Net investment =Net investment income
income This comes from the collected contribution and is invested by Takaful operators to
generate income
Table I. Provision =Provision outstanding claims
Input and output outstanding claims Risks of adverse claims experience that is obtained from uncertainty of outstanding
variables claims and unexpired risks
ln TEit ¼ lnSIZE þ FOREIGNit þ ln PROVCit þ NOBOARDit þ RATIONEit

þ RATIOMUSLIMit þ « (3)
where:
CE = Cost efficiency;
TE = Technical efficiency;
SIZE = Total Assets;
FOREIGN = Dummy variable with foreign participation assigned with a value of
1 and 0 otherwise;
PROV = Provision for Outstanding Claims;
NOBOARD = Number of members on the board of directors;
RATIONE = Number of non-executive members/Number of members on the board
of directors; and
RATIOMUSLIM = Number of Muslim members/Number of members on the board of
directors.
4. Results and discussions

Table II presents the summary of the Takaful operators’ efficiency scores. The Takaful
operators exhibited an average CE of 81.2 per cent; family Takaful exhibited an average CE
of 85.7 per cent; and general Takaful reported an average e of 74.9 per cent. These findings,
therefore, suggest that family Takaful is more cost efficient compared to general Takaful.
Furthermore, the average TE is 91.6 per cent and higher than the average AE at 88.6
per cent. These results also suggest that the Takaful operators in Malaysia are not
managing their firms efficiently in deciding the mix of inputs at a given input price. The cost
efficiency of Takaful operators for our sample in Malaysia showed a value of 0.812 which is
higher compared to the average levels of cost efficiency reported in other Takaful markets in
Parametric test Non-parametric test

Individual test t-test Mann–Whitney test Kruskall–Wallis
Hypothesis Median general Takaful = Median family Takaful Equality of population test
Test statistics t(Prb > 0) z(Prb > z) Chi (Prb > Chi)
Mean t Mean rank z Chi sq.
CE FT 0.857 2.738*** 55.12 2.646*** 1.458**

GT 0.749 40.65
All 0.812
TE FT 0.941 1.576 51.65 1.373 0.848
GT 0.880 45.38
All 0.916
AE FT 0.909 2.085** 54.3 2.464** 1.221*
GT 0.853 41.76
All 0.886
Notes: CE = cost efficiency; TE = technical efficiency; AE = allocative efficiency; FT = family Takaful; GT = general Takaful; All = both family and general
Takaful; * indicates significance at the 0.1 probability level; ** indicates significance at the 0.05 probability level; *** indicates significance at the 0.01 probability
level
efficiency scores
Summary of Takaful
operators’ means
Corporate
governance
Table II.
factors
IMEFM other countries. For instance, Kader et al. (2014) reported an average cost efficiency score of
0.355 for 180 non-life Takaful insurance firms in a sample of 17 Islamic countries between
2004 and 2007, whereas Al-Amri (2015) reported an average cost efficiency score of 0.7553
for 22 Takaful operators in Gulf Cooperation Council (GCC) between 2004 and 2009.
Therefore, from the comparison among Malaysia (score of CE = 0.812), and 17 other Islamic
countries (CE = 0.355) and GCC (CE = 0.7553), Malaysian Takaful operators could achieve
higher cost efficiency compared to the majority of Takaful operators. However, the results
need to be carefully interpreted, as the results may not be accurate in making direct
comparisons of the efficiency levels calculated on different frontiers using different input
and output measures (Kader et al., 2014).
Also observed in Table II is that CE with a score of 0.812 is contributed by TE with a
score of 0.916 and AE with a score of 0.886. This suggests that higher technical efficiency
will result in higher cost efficiency. Moreover, as these two scores are the contributing
factors on the effectiveness of Takaful firms’ management, they will be treated as dependent
variables with the independent variables inclusive of SIZE, PROCV, FOREIGN, NOBOARD,
RATIOMUSLIM and RATIONE.
The results for the impacts of firm-specific factors and corporate governance are
illustrated in Tables III to V. In Table III, the standard deviation for SIZE is 1.65 higher
compared to the other variables and shows that the variation of assets size among the
Takaful operators is higher. Further, the ratio of non-executive directors at an average of
0.94 recommends that the Takaful operators in Malaysia are an oversight by the outside
directors to ensure the alignment of contractual interests in companies.
The most suitable model is the pooled Ordinary Least Square (OLS) model because the
null hypothesis (square of the error term is equal to zero) in the Breusch–Pagan Lagrangian
Multiplier test was not rejected. Pooled OLS is used to present the result based on poolability
of the data but disregards the panel structure of the data. This means that the model
disregards the panel nature of the data and treats the error term as identically and
independently distributed disturbances that are uncorrelated with the independent
variables. Thus, the data can be pooled, and OLS can be used to evaluate the model. The
regression results based on pooled OLS are presented in Table IV.
From Table IV, it can be seen that cost efficiency is positively correlated with the
international diversification structure with foreign participation (FOREIGN) but negatively
correlated with other variables, namely, SIZE, PROVC, NOBOARD, RATIOMUSLIM and
RATIONE. This finding suggests that Takaful operators involved in international
diversification structures with foreign participation appear to be more cost efficient
compared to firms that are not involved in international diversification structures with
foreign participation. Overall, all the correlation values are less than 0.8, therefore
suggesting that there is no serious multicollinearity issue in the model. To verify our
Variable Observation Mean SD Minimum Maximum
CE 97 0.81 0.22 0.20 1.00

TE 97 0.91 0.15 0.40 1.00
lnSIZE 97 19.51 1.65 16.02 22.91
lnPROVC 97 4.71 0.04 4.63 4.74
FOREIGN 97 0.58 0.49 0.00 1.00
Table III. NOBOARD 97 7.17 1.23 5.00 9.00
Descriptive results RATIOMUSLIM 97 0.65 0.23 0.14 1.00
for Takaful operators RATIONE 97 0.94 0.07 0.67 1.00
Variables CE TE AE lnSIZE lnPROVC FOREIGN NOBOARD RATIOMUSLIM RATIONE
CE 1
TE 0.64*** 1
AE 0.76*** 0.01 1
lnSIZE 0.00 0.11 0.10 1
lnPROVC 0.08 0.09 0.20 0.28*** 1
FOREIGN 0.24** 0.04 0.29*** 0.43*** 0.36*** 1
NOBOARD 0.17 0.01 0.22** 0.34*** 0.52*** 0.37*** 1
RATIOMUSLIM 0.10 0.15 0.01 0.24** 0.02 0.16 0.34*** 1
RATIONE 0.10 0.07 0.23** 0.29*** 0.37*** 0.28*** 0.15 0.01 1
Notes: ***Indicates significance at 0.01 level; **indicates significance at 0.05 level
Table IV.
Corporate
the variables
Correlation among
factors
governance
IMEFM justification that there is no serious multicollinearity problem, a variance inflation factors
(VIF) test was conducted resulting in a value of 1.38, which is less than the recognised
threshold value of 10 (Gujarati and Porter, 2009). Therefore, the present study is free from
serious multicollinearity problems.
Table V presents the second stage of the panel regression results to identify the influence
of firm-specific and corporate governance factors to cost efficiency and technical efficiency
of Takaful operators in Malaysia. Generally, the variables do not show a significant impact
on the technical efficiency of the Takaful operators as shown in Models 4, 5 and 6 in
Table V. However, the models with cost efficiency as the independent variables are more
reliable compared to the models with technical efficiency. The independent variables are
because of the adjusted R2 in Models 1, 2 and 3 which are generally higher compared to
Models 4, 5 and 6.
Our explanation for this result will focus on Model 1 given it includes both the general
and family Takaful operators in Malaysia, and its adjusted R2 is the highest. In Model 1, the
coefficient of SIZE is positive but not significant. The result, therefore, suggests that the
asset size of the Takaful operators does not have significant influence over cost efficiency.
With the presence of foreign insurers participating with Takaful operators, the coefficient is
negative but insignificant, which indicates that Takaful market entry by foreign market
participants does not contribute to cost efficiency. However, this result does not confirm the
findings by Huang and Eling (2013), who suggest that foreign market participants
contribute to technical efficiency change. Regarding the provision for outstanding claims
(PROVC), the result shows an insignificant negative relationship towards cost efficiency.
This finding is unable to confirm the suggestion by Cummins and Weiss (1993); Zhang and
Dukic (2013) and Spierdijk and Koning (2014) that described higher reserves could avoid the
default of Takaful firms and enhance efficiency. The negative coefficient showed a contract
result with the hypothesis that was developed which proposed a positive sign. This outcome
suggests that Takaful firms need to be cautious in estimating the amount of provision to
allocate outstanding claims. This is because reserving large amounts of excess funds on the
provision for outstanding claims could cause inefficiency to Takaful firms because of
limited cash flow for other operating purposes.
Interestingly, the board of director’s member size had negative and significant impacts
on cost efficiency. Therefore, this study suggests that a large board may be less cohesive
and more complex to coordinate. Thus, a smaller board size is more appropriate to Takaful
operators in Malaysia. This is because having fewer board members could minimise the
chance of free riding by individual directors and improve decision-making outcomes that
lead to the improvement in cost efficiency. However, this finding is inconsistent with the
findings of Kader et al. (2014). Their sample applies to cross-country analysis consisting of
Takaful operators (approximately 30 to 50 firms between 2005 and 2007) from 17 Islamic
countries, whereas our sample only consisted of 19 Takaful operators in Malaysia.
Therefore, we propose that a smaller sized board is preferable to Malaysian Takaful
operators, but a larger-sized board is preferable to other Takaful operators in other
countries.
Furthermore, RATIONE postulates negatively with a 10 per cent significance level
towards cost efficiency. Therefore, it implies that the higher the proportion of non-executive
directors on the board will deteriorate cost efficiency. Furthermore, this result proposes that
outside directors could have excessive prudence, risk aversion and have higher concerns
regarding compliance with Shariah principle, which could dampen the cost efficiency of
Takaful operators. This result is similar to the study by Kader et al. (2014), but they also
POLS POLS POLS POLS POLS POLS

Model (1) (2) (3) (4) (5) (6)
Dependent variable CE CE CE TE TE TE
Takaful All Family General All Family General
ln SIZE 0.00889 (0.0154) 0.00761 (0.0191) 0.0466 (0.0382) 0.00552 (0.0110) 0.00322 (0.0133) 0.0311 (0.0282)
FOREIGN 0.0436 (0.0597) 0.0266 (0.0686) 0.153 (0.106) 0.0515 (0.0428) 0.0471 (0.0478) 0.0768 (0.0785)
ln PROVC 0.379 (0.503) 0.158 (0.565) 0.447 (0.905) 0.412 (0.361) 0.630 (0.394) 0.303 (0.668)
NOBOARD 0.0530** (0.0243) 0.0424 (0.0254) 0.0170 (0.0557) 0.0216 (0.0174) 0.0273 (0.0177) 0.0122 (0.0411)
RATIONE 0.580* (0.322) 0.549* (0.320) 0.345 (0.775) 0.346 (0.231) 0.120 (0.223) 0.665 (0.572)
RATIOMUSLIM 0.102 (0.106) 0.0706 (0.129) 0.0233 (0.187) 0.0132 (0.0758) 0.0545 (0.0897) 0.141 (0.138)
Constant 3.450 (2.444) 2.304 (2.713) 4.276 (4.527) 0.625 (1.752) 1.720 (1.889) 0.531 (3.341)
Observations 97 57 40 97 57 40
R2 0.076 0.137 0.107 0.064 0.097 0.158
Adjusted R2 0.0762 0.0337 0.0550 0.0017 0.0115 0.0053
Notes: **Indicates significance at 0.05 level; *indicates significance at 0.1 level. Standard errors are reported in parentheses
Panel regression
Table V.
results
Corporate
factors
governance
IMEFM found that the effect of RATIONE towards cost efficiency will turn positive after the board
number exceeded the mean.
Concerning the proportion of Muslim directors on the board (RATIOMUSLIM), the
coefficient is negative but insignificant which could be because of the inadequate proxy
used. A study by Mollah and Zaman (2015) found a Shariah supervision board or Shariah
committee as the proxy for the influence of Islamic governance. On the other hand, most of
the annual reports of Malaysian Takaful operators do not disclose the composition of
Shariah committee members. This observation is consistent with the findings by
Kasim (2012), finding that the Shariah committee should, in fact, report Shariah compliance
information through the annual reporting process; however, evidence suggests that they fail
to do so. Kasim (2012) on the other hand suggests that Takaful operators should be more
transparent in disclosing more information concerning their operations. This is because
there is a lack of information to assist investors and other external stakeholders to make
well-informed judgments on Takaful operators.

As a robust check, this study also performed system GMM two-step estimator with
robust standard errors to identify whether there exists an endogeneity problem to rule out
the effect of the DEA score on the governance factors. From Appendix, Models 1 to 3, none
of the independent variables postulate a significant impact on the dependent variables. It is
therefore suggested that the system GMM model that can address the possibility of the
endogeneity problem in the model which was found to be unsuitable in the analysis. It also
suggests that pooled OLS is sufficient to examine the objective of this study which could be
supported by the sample for five years, which is a short sample period. Another robustness
check used AE as the dependent variable. The robustness check models are provided in
Appendix, Models 4 to 6. Here, it is observed that none of the variables are significant, and
further explains that the contributing factors on the effectiveness of Takaful firms’
management were cost efficiency and technical efficiency.
Overall, no evidence was found on the firm-specific factors towards cost efficiency and
technical efficiency on Takaful operators. However, from a corporate governance
perspective, a higher board number in size and a higher composition of non-executive board
members will harm overall cost efficiency.
5. Conclusions
This study uses DEA to examine the efficiency of 11 family Takaful and 8 general Takaful
operators in Malaysia between 2011 and 2015. Several significant findings are found in this
research. First, family Takaful is more cost efficient compared to general Takaful.
Generally, Takaful operators in Malaysia are not managing the firms efficiently in deciding
the mix of inputs at the given input price (allocative inefficiency). This component causes a
reduction in cost efficiency. The cost efficiency of Takaful operators for the sample in this
study in Malaysia shows higher average cost efficiency compared to other Takaful markets.
Second, corporate governance factors do influence cost efficiency; however, no evidence
was found on the firm-specific factors towards cost efficiency and technical efficiency of
Takaful operators. Board size and the proportion of non-executive directors impose a
negative significant relationship regarding cost efficiency. This is because a large board
may be less cohesive and more complicated to coordinate.
Similarly, non-executive directors could have excessive prudence and risk aversion
resulting in higher concerns about compliance with the Shariah principle which could
dampen the cost efficiency of Takaful operators. Finally, Takaful operators should be more
transparent to disclosure further information regarding their operations to facilitate
investors and other external stakeholders in drawing well-informed opinions and views on
Takaful operators. This is because most of the annual reports of Malaysian Takaful Corporate
operators fail to disclose the composition of Shariah committee members. Therefore, by governance
increasing the transparency of information disclosure, it could help to boost the consumers’
confidence of Takaful firms and enhance their accountability (Kasim, 2012). As a result, it
factors
could help in promoting Malaysia as an Islamic financial centre. We believe that this study
could have important policy implications. Given allocative inefficiency will result in cost
inefficiency, Takaful operators could increase the engagement of experienced and talented
non-executive directors on the board, by elucidating their responsibilities in counselling on
strategic and operational issues such as resource allocation and usage.
Moreover, regulators in Takaful markets could strengthen their supervisory and
regulatory oversight of the Takaful industry by introducing an effective Shariah
framework. This will help to ensure that Takaful operators are complying with Shariah
principles and transparent reporting practices relating to Shariah compliance information.
This will help to ensure that the Takaful market could support this feature in Islamic
banking and finance by strengthening its development and use in the Takaful market.
To improve the examination on the issues of efficiency, firm-specific and corporate
governance factors of Takaful insurance, future researchers could use advanced efficiency
estimation methods to address outlier and dimension issues in estimating the scores for
efficiency as performed by Ghulam and Jaffry (2015). They should first begin with DEA
estimators and proceed in their discussion with more advanced estimators, namely, order-m,
a-quantile and the hyperbolic order-a quantile estimator.
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Corresponding author
Hui Shan Lee can be contacted at: huishan.leehuishan@gmail.com
results
IMEFM
Table AI.
on the regression
Robustness checks
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Appendix
SysGMM SysGMM SysGMM POLS POLS POLS

Model (1) (2) (3) (4) (5) (6)
Dependent variable (DV) CE TE AE AE AE AE
Takaful All All All All Family General
Lag of DV 0.103 (0.240) 0.557 (0.359) 0.0210 (0.119)

ln SIZE 0.0116 (0.0272) 0.0429 (0.0297) 0.000823 (0.0109) 0.0101 (0.0126) 0.0175 (0.0168) 0.0345 (0.0843)
FOREIGN 0.440 (0.0148) 0.104 (0.0135) 0.352 (0.0114) 0.00829 (0.0476) 0.0709 (0.0540) 0.102 (0.0875)
ln PROVC 0.0407 (0.0245) 0.0207 (0.0140) 0.0107 (0.0164) 0.0166 (0.0794) 0.0151 (0.0870) 0.0561 (0.0754)
NOBOARD 0.0600 (0.107) 0.0408 (0.0728) 0.0380 (0.0470) 0.0252 (0.0194) 0.0132 (0.0200) 0.0145 (0.0459)
RATIONE 0.297 (0.719) 0.663 (0.457) 0.567 (0.408) 0.163 (0.252) 0.364 (0.251) 0.378 (0.616)
RATIOMUSLIM 0.005 (0.028) 0.507 (0.021) 0.459 (0.017) 0.130 (0.0842) 0.0455 (0.102) 0.226 (0.159)
Constant 0.964 (1.546) 1.396 (1.476) 1.472*** (0.436) 1.392*** (0.418) 1.221*** (0.447) 1.142 (0.995)
AR(1)-p value 0.476 0.109 0.076
AR(2)-p value 0.865 0.424 0.597
Observations 77 77 77 97 57 40
R2 0.134 0.195 0.180
Adjusted R2 0.077 0.099 0.031

Efficiency, Firm-Specific and Corporate Governance Factors of The Takaful Insurance

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Efficiency, Firm-Specific and Corporate Governance Factors of The Takaful Insurance

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Efficiency, firm-specific and corporate governance factors of the Takaful

Hui Shan Lee Fan Fah Cheng

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Har Wai Mun Annuar Md Nassir

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Profitability Determinants of Information Technology Software Companies in Malaysia View project

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Journal of Islamic and Middle Eastern Finance and Management, https://doi.org/10.1108/

*Related content and download information correct at time of download.

Efficiency, firm-specific and Corporate

of the Takaful insurance

Fan Fah Cheng

2.2 Eﬃciency and data envelopment analysis

2.3 Hypothesis development

the board [of directors] (RATIOMUSLIM).

ln CEit ¼ lnSIZE þ FOREIGNit þ ln PROVCit þ NOBOARDit þ RATIONEit

ln TEit ¼ lnSIZE þ FOREIGNit þ ln PROVCit þ NOBOARDit þ RATIONEit

4. Results and discussions

Parametric test Non-parametric test

CE FT 0.857 2.738*** 55.12 2.646*** 1.458**

Variable Observation Mean SD Minimum Maximum

CE 97 0.81 0.22 0.20 1.00

Variables CE TE AE lnSIZE lnPROVC FOREIGN NOBOARD RATIOMUSLIM RATIONE

Notes: ***Indicates signiﬁcance at 0.01 level; **indicates signiﬁcance at 0.05 level

POLS POLS POLS POLS POLS POLS

well-informed judgments on Takaful operators.

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SysGMM SysGMM SysGMM POLS POLS POLS

Lag of DV 0.103 (0.240) 0.557 (0.359) 0.0210 (0.119)

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CE FT 0.857 2.738* 55.12 2.646* 1.458**

Notes: *Indicates signiﬁcance at 0.01 level; indicates signiﬁcance at 0.05 level