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PhD and MIF Programs

Project Paper

An Overview of Takaful in Malaysia

Corporate Finance

FN 5033/6033

Professor Dr. Shamser Mohamad

September 2012- Semester

Name Student ID Programme

Mace Abdullah 1000491 PhD

Yerkebulan Amanbayev 1100079 MIF

Gamal Salih Omer 1200073 PhD

Ahamed Elobied 1200074 PhD

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Abstract

Takaful is the Islamic alternative to insurance; it is not insurance per se. The Arabic word for

insurance is tamein, which means to reassure or guarantee through indemnification of losses.

Conventional insurance uses voidable (fasid) contracts called policies through which

individuals or firms receive indemnification against losses. Conventional insurance

companies pool policyholder risks in a form of risk intermediation. Each policy is privately

owned. Takaful, by contrast, not only pools risks, but also pools funds through the use of

contracts that are Shari’ah-compliant. Takaful is not what it purports without compliance

with its religious norms and prohibitions. Although Takaful must still be regarded as nascent,

it has shown remarkable growth in Malaysia. As Takaful grows it will inevitably intersect

with insurance, aspiring to replace insurance as the preferred mode of risk intermediation.

However, Takaful will need to answer many questions along that arduous trek. Can Takaful

compete with conventional insurance in the areas of risk management, financial performance

and innovation? Will Takaful adhere to its epistemology along the way, or will it mimic

conventional insurance? Malaysia is a world leader in Takaful. The answers to these

questions may well be answered in Malaysia. This paper analyzes recent financial data,

Malaysia’s regulatory and oversight regime, Takaful’s risk profile and other factors to draw

an analytic picture of Malaysia’s Takaful industry.

Key terms of the research

Takaful, Insurance, Takaful risks, Insurance risks, Malaysian Takaful, Takaful financial

intermediation

Objectives of the research: The objectives of this analytic research are to:

Assess the development of Takaful in Malaysia

Compare Takaful with conventional insurance in Malaysia

Compare Takaful in Malaysia with Takaful worldwide

Identify Takaful’s risk profile

Evaluate Takaful’s financial role in Malaysia

Examine Takaful’s financial performance

Discuss Takaful’s growth prospects

Assess the future of Takaful in Malaysia

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Table of Contents

I. Introduction

A. Epistemology

B. Historical Background

II. Shari’ah Norms and Prohibitions

A. Distinctions from Conventional Insurance

B. Shared Attributes with Conventional Insurance

III. Takaful in Malaysia

A. Evolution & Development

B. Current Status

C. Organizational Models

D. Malaysian Classifications

E. Taxation in Malaysia

IV. Regulatory Oversight & Standard Setting

A. Legislative History

B. Bank Negara Malaysia

C. Islamic Financial Services Board (IFSB)

D. Accounting Association of Islamic Financial Institutions (AAOIFI)

E. Role of Shari’ah Boards & Committees

F. Fatawah

V. Risk Attributes of Takaful

A. Risk Profile

B. Risk Intermediation

C. Retakaful

D. TIPS

VI. Financial Attributes of Takaful

A. Financial Intermediation

B. Capital Structure

C. Growth Patterns

VII. Conclusion & Findings

References

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I. INTRODUCTION

A. Epistemology1

Islamic financial institutions have a collective religious obligation (fard kifayah)

imposed upon them by the Shari’ah. This obligation includes the necessity for Shari’ah-

compliant financial intermediation in a Shari’ah-compliant manner. It mandates the need to

preserve wealth and mitigate harm (Farook 2007). Takaful, as a key Islamic financial

institution, has religious obligations concomitant with its roles in the Islamic financial

system. Technically, its primary roles are risk mitigation and financial intermediation.

Religiously, its primary roles are social wellbeing and mutual assistance. These roles must be

reconciled periodically to insure that Takaful retains its pristine purpose.

Takaful is firmly grounded in religious commands (talab) and obligations (ijab). Yet

Takaful is not explicitly prescribed in Shair’ah, i.e. by name. Rather, mutual support and

assistance are commanded and are fundamental to Islamic social wellbeing and the Islamic

financial system. Almighty Allah advises those who believe (mu’mineen):

"O you who believe…assist (ta’awanu) one another in birr (the doing of good)

and taqwa’a (having consciousness of Allah). Assist not one another in sin and

transgression, but keep your duty to Allah" (Qur’an 5:2)2.

Islam requires brotherhood and solidarity among believers and steadfastness against

those who seek to cause harm; economically or otherwise. Almighty Allah advises the

believers:

“And hold fast (cling) to the rope (habl) of Allah all together (jami’aa) and do not

be divided…” (Qur’an 3:103).

The Arabic word “habl” has etymological meaning of a promise of assurance, security, or

safety and a thing well known to which one clings, causing unity (Lane 1863). In short, it

implies solidarity.

The importance of solidarity among the believers has been emphasized by the

Prophet, AS3. Abu Musa, RAA

4, reported Allah's Messenger, AS, as saying:

“A believer is like a brick for another believer; the one supporting the other”

(Sahih Muslim, Bk. 32, #6257).

And he emphasized the common interests and shared concerns of believers, when he said:

“You will see the believers in regard to their mutual love, affection and

compassion, like the example of a single body; when any limb aches, the whole

body aches” (Sahih Bukhari #6011 and Muslim #2586 with similar phrasing in

Musnad Ahmad).

These textual proofs of the call to solidarity and mutual assistance to stave-off harm

are buttressed by numerous legal maxims (quwaid al-fiqhiyyah) that support the common

1 Simply put, epistemology is the study of knowledge and seeks to distinguish between what we believe to be true

knowledge from that which we believe to be false knowledge.

2 References to Qur’an in this paper, refer to a translation by Muhammad Mohar Ali (former professor of History at

Madinah University and graduate of Imam Muhammad University, Riyadh, KSA), “A Word for Word Meaning of the

Qur’an” (Jami’yat ‘Ihya’a Minhaaj as-Sunnah (Ipswich, Suffolk 2003).

3 AS is used throughout this paper stands for the prescribed salutation upon the Prophet of Peace be upon him.

4 Throughout this paper, the term RAA is in reference to the honor Muslims are instructed to give to the companions of

the Prophet, AS, i.e. “Radhi Allaahu anhu” or may “Allaah be pleased with him.”

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responsibility of mitigating harm. For example: “Hardship is to be alleviated” (al-mashaqqa

tajlub al-tasysir) and “Prevention of harm takes priority over securing of benefits” (dar al-

mafasid awla min jalb al-manafi). (Kamali 2006).

Accordingly, Muslim scholars have concluded that among the ultimate objectives of

the Shari’ah is that of serving the interests of all human beings (jalb al-masaalih) and to save

them from harm (daf’a al-mafasid). (Bouheraoua 2011). Preservation and protection of the

essentials of human beings is established under the Objectives of Islamic Law (Maqasid ash-

Shari’ah) as necessities of life (dururiyyat). These essential rights that are to be preserved

include the protection of: faith (din), life (nafs), family (nasl), intellect (‘aql) and property

(ma’al). Ibid.

Thus, Islam calls mankind to engage in mutual cooperation or assistance (ta’awun) in

preserving and protecting from harm those things deemed good, including property, family

and life itself. It is well established Fiqh, that “(d)ifficulty begets facility; that is to say,

difficulty is the cause of facility and in time of hardship consideration must be shown”

(Mejella, Article 17). And the command that “Harm must be eliminated” (adh dharar

yuzaal), which is another legal maxim derived from the Hadith narrated by Ibn Abbas, RAA,

that the Prophet, AS, said: “Neither harm nor be harmed” (laa dharar wa laa dharaar). (Ibn

Majah).

B. Historical Background

That Takaful has religious roots is undeniable. Yet, as is the case with other forms of

human dealings (mu’amulat), it also finds its genesis in early forms of mutual cooperation.

The Prophet, AS, saw some of these practices among the Arabs, e.g.:

Merchants of Makkah formed funds to assist victims of natural disasters or hazards of

trade journeys (museebah). This was a form of surety called damman khatr al-tariq

and was based on perceived risks of loss due to hazards on trade routes.

Contracts, called aqd muwalat, were entered into for bringing about an end to mutual

enmity or revenge.

Alliances were formed by means of hilf or confederacy agreements.

Assistance relating to the payment of “blood-money” or diyah was provided to

captives and the families of murder victims (qisas) through a tribal form of assistance

known as ‘aqilah. (Obaidillah 2005).

It is ‘aqilah from which Takaful can trace its Fiqh origins back to the time of the

Prophet, AS, wherein he rendered judgment on the doctrine of ‘aqilah. The Prophet, AS,

being aware of this tribal practice, is reported to have used ‘aqilah in his rulings as follows:

“Narrated by Abu Hurairah (RAA), he said that once two women from Huzail clashed

when one of them hit the other with a stone which killed her and the baby in the

victim’s womb. The heirs of the victim brought an action to the court of the Prophet

(AS) who gave a verdict that the compensation for the foetus to be a male slave or

female slave while the compensation for the killed woman is a blood money (diyat) to

be paid by the ‘aqilah (the relatives of the father’s side) of the killer.” Bukhari, Vol. 9,

# 45.

And as noted by Obaidillah, the Sahifatul Madinah or Constitution of Madinah,

enacted by the Prophet, AS, assured certain forms of ta’awun or mutual cooperation would be

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implemented and upheld. Obaidillah explains that it contained three (3) aspects of ta’awun,

including:

“Provision for social insurance affecting the Jews, Ansar and the Christians.

Statement that "the immigrants among the Quraish shall be responsible for their

word and shall pay their blood money in mutual collaboration."

Provision for ransom (fidya) whereby payment is made to rescue the life of a

prisoner and the relatives (‘aqilah) could cooperate to free him.”

Thus, the Prophet, AS, took a tribal custom and transformed it into a rule of law

(hukm ash-Shari’ah) for mitigating harm by and among the people. It can be seen from the

above that Takaful has its origin in customs or ‘urf or abah of the Middle East. It can be said

that it is part of the Sunnah of the Prophet, AS, that he acquiesced in matters of ‘urf or adah

that contained good in them (a form a Sunnah called Sunnatul taqririyyah or tacit approval).

(Kamali 1991).

‘Urf is an Arabic word that connotes “knowing.” It is established practices among

people (well known) that are deemed to be beneficial and for their wellbeing. One of its

characteristics is that it is communal and practiced throughout the society repeatedly and

continuously (OIC 1988). Thus, its prevalence is al-amm or general. It must have attributes of

being sound and reasonable. It may be verbal, but in this instance, the form being identified is

that of a practice (‘urf fi’li). (Nyazee 2004).

‘Urf cannot contravene the Shari’ah. As is the case, in general, with other forms of

mu’amulat, its starting point, absent a textual prohibition found in Qur’an and Sunnah, is that

of permissibility (mubah or ibahah). Later, such practices may be accepted by the Shari’ah,

either by judgment as can be seen from the Hadith of Abu Hurairah above, or by tacit

approval. Thus, we find the legal maxim: “Custom (‘adah) is the basis of judgment” (al-

'adatu mu˙akkamtun). (Mejella Article 36).

II. SHARI’AH NORMS AND PROHIBITIONS

A. Distinctions from Conventional Insurance

Takaful means “guaranteeing each other” in Arabic. Etymologically, its root comes

from the Arabic “kafala;” which is, of course, one of Islamic Finance’s intermediate

contracts. It is a system of Islamic insurance based on the principle of mutual assistance

(ta’awun) and donation (tabarru’) where risk is shared collectively by a group of participants

voluntarily. This is a pact among a group of members or participants who agree to jointly

guarantee among themselves against loss or damage to any of them as defined in their

contracts.

Shari’ah Norms. Takaful has 5 key elements that normalize it for Shari’ah purposes.

They are self-explanatory, for the most part, and include:

Gratuitous mutual contributions and guarantee of losses divided between participants,

i.e. in which case the participants are both the insurer and insured and all participants

are aware that they face similar risks and are willing to contribute to the misfortune of

any member.

Ownership of the Takaful fund and retaining mutual (versus private) ownership

interests therein, including its profits.

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Avoidance of oppression (zulm), unfairness, injustice and exploitation (istighlal) and

an understanding that their affairs are to be conducted openly in accordance with the

utmost faith, good, honesty, transparency, truthfulness and equity.

Management of the Takaful fund through the use of Shari’ah-compliant contracts, e.g.

mudharabah or wakalah.

Investment conditions necessitate that all investments must be Shari’ah-compliant;

thus, prohibiting investment in impermissible or haram industries and requiring the

use of investment instruments that are Shari’ah-compliant.

Shari’ah Prohibitions. Conventional insurance contains three features that are

prohibited by the Shari’ah. They are:

Major Uncertainty (Gharar Fahish): Transactions should be free from excessive

uncertainty. Excessive, unacceptable uncertainty is caused by the lack of information

or disclosure (jahl), which leads to ambiguity (taghreer), lack of “mutual consent”

(ridha), misrepresentation (ghabn) or exploitation. Thus, making a contract of

insurance unduly complex, verbose or combining within it, two or more other

contracts, can easily lead to gharar. Misleading advertising and marketing

(khalabah) can lead to misrepresentation and exploitation of the unwary. All or some

of these characteristics in any commercial contract, including insurance contracts, can

render the contract defective and thus voidable (fasid5). Voidable contracts can still be

honoured and they may be reformed. This implies that they are not totally invalid, but

there is language or provisions in them that are unacceptable to Shair’ah. It should be

noted that more gharar is accepted in charitable, unilateral contracts (at-tabarru’at)

than in purely commercial transactions. This latter Shari’ah principle buttresses the

validity of Takaful contracts.

Gambling (Maisir or Qimar): Gambling is not permissible under Shari’ah. In

gambling, one party is always hoping for a gain at the cost of another party loosing

(qimar); the so-called “zero sum game.” Alternatively, one party may hope or

“gamble” on a “windfall” or large gain with little or inordinately small counter-value

(maisir). In the context of insurance, the policyholder hopes (bets) to gain a large sum

from his small amount of contribution. What the policyholder actually hopes is that

the claim will exceed his contribution. Thus, pooling of interests helps to avoid

individual gain caused by individual greed or fraud. In this case, the company would

probably be in deficit.

However, the policyholder would lose the money paid for premium if the

insured event does not occur, e.g. with certain so-called “term life” policies. These

policies insure the life of the policyholder for a term of years; thereafter, the party is

left uninsured if (s)he outlives the “term.” Furthermore, only a proportional refund

would be made if the contract is terminated by the insurance company. Worse yet,

some conventional policies demand payment of the entire premium for the initially

insured period, even if the policy is terminated or forfeited by the insured.

5 Fasid means voidable in the majority of mudhahib (schools of religious law), but may mean invalid in the Shafi’ee

madhab.

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Interest (Riba): Any insurance contract wherein the policyholder expects to obtain a

fix amount of profit that is greater than what he has contributed is considered as riba.

That is because, by and between him or her and the insurance company, there is an

exchange (and some might say an exchange of money), wherein one side lacks the

equivalent counter-value or consideration. Other Shari’ah violations occur if the

exchange is considered an exchange of money, and deemed bai’ as-sarf. Furthermore,

investing premiums in financial instruments that are not Shari’ah-compliant usually

involve prohibited elements of riba (e.g. interest) and maisir. Hence, the

conventional insurance is prohibited under Shari’ah on a variety of grounds

emanating from the prohibition against riba on all levels, i.e. shareholder,

underwriting and investment funds.

B. Shared Attributes with Conventional Insurance

Certainly, Takaful is an adaption of customs that were prevalent before the advent of

Islam. It has never been said that Islam is the first religion, but rather the completion or

fulfilment of that which came before it, in its pristine form (Qur’an 2:97). That said, the roots

of conventional insurance can be traced back to the Chinese. Around 5,000 BCE, Chinese

traders spread their merchandise over several ships, instead of putting all their property on

one ship. If one ship sank, no individual trader bore the loss. If two traders spread their

goods over two ships and one sank, each trader lost only half of his goods rather than

everything (CGU 2004). The Babylonians, in the 3rd

and 2nd millennium BCE, also engaged

in insurance practices of risk transference and the latter codified such practices in the Code of

Hammurabi, circa 1750 BCE6.

These were early methods of transferring or distributing risk, practiced by Babylonian

and Chinese traders and early Mediterranean sailing merchants. Similarly, if a merchant

received a loan to fund his shipment, he would pay the lender an amount of interest much

higher than the market average in exchange for the lender's guarantee. If the shipment was

never received, the lender lost his money and the loan was considered cancelled (Ajmi 2005).

As has been shown, both Takaful and conventional insurance have connection to these

earlier practices, though different epistemologically. However, one must make some

distinction between what is known conventionally as mutual insurance and what can be

called stock owned insurance. The former is owned by the participants (as in Takaful), while

the latter is owned by 3rd

party investors, whose primary motive for involvement with the

insurance company is profit.

Table 1 illustrates the similarities and differences between the 2 models of

conventional insurance and Takaful. Dawood Taylor, Senior Regional Executive-Takaful

Middle East, of Prudential Corporation Asia, compared conventional mutual insurance with

Takaful at the World Takaful Conference in Dubai in 2010. The primary difference between

the two models is the epistemological origins and the Shari’ah norms and prohibitions related

to riba (Taylor 2010). Thus, it can be said that the differences with conventional insurance

practices is less significant with mutual insurance companies than with stock insurance

companies.

).pedia.org/wiki/Insurance#History_of_insurancehttp://en.wiki

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Table 1-Comparison Between Conventional Insurance & Takaful

Characteristic Mutual Insurance Stock-Owned

Insurance

Takaful

Contractual relationship Risk sharing by the

policyholder-owners within

the mutual company

Commercialized buy-

sell or exchange

contract.

Tabarru or unilateral

gratuitous promise to

contribute, combined at times

with wakalah (agency) and/or

mudharabah (partner) operator

agreements.

Economic goals Provide value to the

policyholders-owners.

Possible conflict of interest

between board, managers and

policyholder-owners.

Based on profit-

motive to maximize

profit to shareholders.

An inherent conflict

of interest between

shareholders,

managers and

policyholders..

Based on the motive of

community welfare, protection

and mutual assistance; the

presence of a 3rd

party operator

or manager does not

circumvent that primary goal.

Governance Board of directors and

managers run the company "in

trust" for policyholders.

Policyholders have the right

to appoint board of directors,

and the board of directors

appoints management.

Boards of directors

elected by

shareholders;

managers appointed

by board.

SAC, Shari’ah advisory

boards or committees and

boards of directors. Operators,

as agents or partners must

adhere to Shari’ah,

governance and prudential

principles.

Premium payments, surpluses

& profits

Policyholders pay premiums

to the mutual pool; surpluses

& deficits are allocated to the

accounts of policyholders; and

surpluses can be retained for

reserves against future claims.

Policyholders pay

premiums, which are

for specific insurance

coverage over a

specified timeframe;

premiums may

contain an investment

feature; surpluses and

income from

investments belong to

the insurance

company and the

income from any

investment feature is

based upon a “fixed”

annuity type contract.

Taxes are paid on

profits and dividends

to shareholders

Contributions by participants

are gratuitous and pooled, but

held in individual participant

special accounts (PSA);

savings or investment feature

may be present in family plans

and are placed in

individualized participant

accounts (PA); if no event

before maturity, participants

receive the “balances” of their

PA, PSA and proportionately

valued share of surpluses;

surpluses are wholly owned by

participants unless wakalah

and/or mudharabah operators

access as fees or profit

sharing. Zakat is paid on

surpluses.

Liability of

Insurer/operator

Mutual pool is liable on

claims.

Underwriting claims

are paid from

premiums collected,

investment income

allocable to the

insurance company’s

capital or assets to

provide the face value

of coverage; insurance

company may finance

its activities with

conventional debt or

equity shares

proceeds.

Claims are made from PA and

PSA first. Then, from the

Takaful fund; in the case of

deficits, qard hassan or a

benevolent loan can be made

by an operator to the fund.

Access to capital No access to share capital, but

possible use of subordinated

debt.

Insurance company’s

capital is at risk. Debt

may be used.

Access to capital of operator

through use of Qard Hasan.

Investment of funds No restrictions except for

those imposed for prudential

reasons.

No restrictions except

for those imposed for

prudential reasons.

Resticted to Shair’ah-

compliant investments,

including avoidance of gharar.

(Adapted from Taylor 2010) Permission granted.

It is instructive to note that many, if not most, mutual insurance companies in the

West have de-mutualized and become stock-owned insurance companies. Apparently all that

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is needed is a majority approval by the policyholders and approval by the regulator. Such

large insurance companies as Liberty Mutual, New York Life, Metropolitan Life, John

Hancock and Prudential, all started out as mutual insurance companies, but were

subsequently de-mutualized (Rambeck 2001). This would appear to be an area of inquiry for

research as Takaful grows and the most efficient models are compared, i.e. what makes one

form of operation more efficient or effective than another.

Insurance is permissible in Islam when undertaken in the framework of Takaful or

mutual guarantee and ta’awun or mutual cooperation. It is a pooling of unilateral promises

among a group of people with common interests to protect and guarantee each other from a

certain class of misfortune. It is based on sincerity and willingness of the group to help

anyone among them. The similarities with mutual insurance companies are remarkable.

However, Takaful’s differences from conventional insurance are much starker when

compared to the commercialized aspects of stock-owned insurance companies. These

conventional insurance companies offer and sell protection at a certain cost or price and for

profit. Each contract is individual and the private property of the policyholder and the actual

owner of the policy may be someone who has an insurable interest in the inured person or

property being insured.

Because 3rd

party investors and the managers they appoint may have the incentive to

maximize their profits at the expense of the policyholders, there is a stronger conflict of

interests between shareholders of the insurer company and the policyholders. Moreover, this

agency problem may also cause managers of the insurance company, who may have bonuses

or other forms of compensation tied to performance incentives, to minimize claim payments

or benefits, or to raise premiums in order to maximize profits.

Although Takaful funds do have 3rd

party operators (who manage the fund on the

basis of wakalah or mudharabah), Takaful funds in Malaysia are subject to a regiment of

regulatory oversight and Shari’ah governance. Shari’ah governance is effectuated by the

standards applicable to Takaful funds promulgated by the Shari’ah Advisory Council (SAC)

of Bank Negara Malaysia (BNM). The “Islamicity” of the fund is safeguarded further by its

own Shari’ah advisory committee or board, which functions at the fund level to insure that

products, services and operational activities are Shari’ah complaint. Moral hazards, which

may arise in conventional insurance, are frowned upon in Takaful. Such moral hazards may

include the conflicts of interests discussed herein, agency problems, as well as zulm and other

unfair and undesirable features of commercial activities. Moreover, the emphasis placed on

Shari’ah governance in Malaysia particularly, illustrates the epistemological differences

between Takaful and conventional insurance.

III. TAKAFUL IN MALAYSIA

A. Evolution & Development

In 1979, Sudan started the 1st Takaful fund, the Islamic Insurance Company of Sudan

(Ajmi 2005), a little more than a year after a fatwa by the Saudi Arabian Council of Head

Scholars (24/3/1977) denouncing conventional insurance contracts as being imbued with

gharar. Later that same year, the Islamic Arab Insurance Company of Saudi Arabia was

formed. (Ernst & Young 2012). Malaysian scholars quickly followed in 1982 by denouncing

life insurance contracts. Malaysia was already well along the way to an Islamic financial

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system, when in 1963, Tabung Haji became the first Islamic institutional investor. The first

Takaful fund was started in Malaysia in 1984, one year after establishing its first Islamic bank

(Laldin 2008).

The development of the Takaful industry in Malaysia in the early 1980s was inspired

by the prevailing needs of the Muslim public for a Shariah-compliant alternative to

conventional insurance, as well as to complement the operation of the Islamic bank that was

established in 1983. It was, to a large extent, triggered by the decree issued by the Malaysian

National Fatwa Committee which ruled that conventional life insurance policies were fasid

due to the presence of gharar (excessive uncertainty), riba’ (usury) and maisir (gambling). A

Special Task Force was established by the Government in 1982 to study the viability of the

setting up of a Takaful fund. Following the recommendations of the Task Force, the Takaful

Act was enacted in 1984 and the first Takaful operator was incorporated in Malaysia in

November 1984.

Malaysian Takaful has experienced rapid growth and transformation since its

inception 28 years ago. It has grown from a single player with limited basic products to 12

Takaful and 4 Retakaful operators; all integrated into the mainstream financial system. This

was achieved through the concerted efforts of Bank Negara Malaysia (BNM) and the Takaful

operators in developing a dynamic, resilient and efficient Takaful industry. In developing

Takaful in Malaysia, BNM has adopted a gradual approach which can be divided into three

phases as shown below.

Phase I (1982-1992) started with the enactment of a dedicated regulatory law, the

Takaful Act 1984 (still the only statute globally that is fully dedicate to Takaful

undertakings), to govern the conduct of Takaful funds, and for the establishment of Shari’ah

committees to ensure that the business operations of a Takaful operator are in compliance

with Shari’ah principles at all time, and the establishment of the first Takaful operator in

1984–Syarikat Takaful Malaysia. The primary focus during this period was the establishment

of the basic infrastructure.

Phase II (1993-2000) marked the introduction of competition with the entry of

another Takaful operator–Takaful National Sdn. Bhd. This period also saw greater

cooperation among Takaful operators in the region including the formation of the ASEAN

Takaful Group in 1995 and the establishment of ASEAN Retakaful International (L) Ltd. in

1997. This has facilitated retakaful (reinsurance) arrangements among Takaful operators in

Malaysia and in the region; namely Brunei, Indonesia and Singapore. It also saw the

appointment of members of the National Shari’ah Advisory Council for Islamic Banking and

Takaful. In addition to this, Takaful Malaysia and Takaful National (now known as Etiqa

Takaful) jointly developed a Code of Ethics in 2000.

Phase III (2001-2010) began with the introduction of the Financial Sector Master

Plan (FSMP) in 2001 which, among other objectives, is to enhance the capacity of the

Takaful operators and strengthen the legal, Shari’ah and regulatory framework. The section

of the (FSMP) which relates to Islamic banking and Takaful is a road map towards realizing

the aspiration of Malaysia becoming an international centre for Islamic finance. This period

has so far witnessed an increased pace of development and competition with the licensing of

new operators i.e. setting up of Ikhlas Takaful operator in 2002, issuance of four new Takaful

licenses between 2005–2007.

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To further promote the development of Takaful, the Malaysian Takaful Association

(MTA), an association for Takaful operators, was established in 2002. The MTA aspires to

improve industry self-regulation through uniformity in market practices and in promoting a

higher level of cooperation among the players in developing the industry.

Also, during this phase, the Malaysian International Islamic Financial Center (MIFC)

was established in 2006 to develop intermediary linkages to the global market place. The

MIFC also promoted the liberalization of the Takaful Industry in 2009, which saw the

issuance of 4 new family Takaful licenses in 2010. These new Takaful players added

significant value to Malaysia’s development of Takaful. Moreover, given the push for the

introduction of more stringent capital requirements, Malaysia has extended the discussion on

risk based capital (RBC) to Takaful.

B. Current Status of Takaful in Malaysia

Takaful is now a core segment of Malaysia’s status as a worldwide Islamic Finance

“hub.” It is part of an “end-to-end” Islamic Finance system. Today, Malaysia has 12 Takaful

operators, 9 Malaysian (M) and 3 foreign-owned (F) owned:

AIA-AFG (F) Great Eastern (F)

ING Public (F)

AmFamily (M) CIMB Aviva (M)

Etiqa Takaful (M) Hong Leong MSIG (M)

HSBC Amanah (M) MAA Takaful (M)

Prudential BSN (M) Syarikat Takaful (M)

Takaful Iklas (M)

Also, there are currently 4 Retakaful operators, 2 Malaysian (M) and 2 foreign-owned (F):

MNRB Retakaful (M) ARC Re Takaful SEA (M)

Munich Retakaful (F) Swiss Re (F)

Worldwide there are less than 200 Takaful operators and less than 20 Retakaful

operators. Malaysia has 6 conventional life and general insurance companies; 2 are

Malaysian and 4 are foreign-owned: Etiqa (M), MCIS Zurich (M), AIA (F), ING (F),

Prudential Assurance (F) and Zurich Insurance Malaysia (F). There is 1 conventional

reinsurance operator and it is foreign-owned, i.e. Hannover Ruechversicherungs AG (F).

However, as will be shown later, Malaysian Takaful contributions still lag far behind

Malaysian conventional insurance premium. As can be seen, some of the conventional

“players” have opened Takaful operations, utilizing their resources and insurance expertise to

seize the Takaful opportunities.

In Malaysia, Family Takaful is larger, but General Takaful is gaining traction. As of

2011, Takaful contributions were about .6 of 1% of Malaysia’s Gross National Income and

approximately 10% of total insurance premiums (BNM 2012). Worldwide, Takaful is a

projected $12 billion dollar industry in 2012, according to the most recent Ernst & Young

(E&Y) World Takaful Report; after being $8.3 billion in 2011 (after adjustment for inflation).

Conventional insurance worldwide is a $4.6 trillion dollar industry by comparison (Ernst &

Young 2012).

13

C. Business Models

Takaful operators use several different models to fulfill their roles as providers of

Takaful. The primary models are named after their underlying secondary contracts under the

Islamic Finance system. They include tabarru, wakalah, mudharabah, waqf and the hybrid

models (Alhabshi 2012).

Tabarru (Donation) -Based Takaful. The tabarru-based Takaful is the most ideal

model of Takaful among other models. Initially, Takaful was seen as a non-profit oriented

activity. This model is based on solidarity, responsibility and brotherhood among

participants. In this model, each participant is willing to make donation to the Takaful fund

with sincere intention to extend financial assistant to other participants faced with difficulties.

It provides no return for both the Takaful operator and the participants. Therefore, such model

is viewed as impeding large-scale expansion of Takaful business (Ibid).

Mudharabah-Based Takaful. Mudharabah is an Arabic term that comes from darb

fil-ard, meaning to journey through the earth seeking the Bounty of Almighty Allah. Under

this model, the participants make contributions that are credited to a participants’ fund, while

the shareholders of the Takaful operator company contribute to a shareholders’ fund which is

different from the participants’ fund. The Takaful operator, as mudharib, invests the

participants’ fund in Shari’ah-compliant instruments. Profits generated from the investment

are shared between the participants and Takaful operator in the agreed ratio. Any losses are

charged to the participants’ fund. In a mudharabah concept, operational expenses relating to

investment are charged to the shareholders’ fund. In managing the operations, general and

administrative expenses other than relating to investments are charged to the participants’

fund. As valid claims are made, Takaful benefits are paid to beneficiaries depending upon

occurrence of actual losses and damages. In case of surplus, the participants receive full

refund, but have to make additional contributions if a deficit exists (Ibid).

Wakalah-Based Takaful. Under the wakalah-based model, the Takaful operator

performs as the wakil or agent of the participants and is consequently entitled to a fee for the

services provided. In theory, the participants’ contributions are credited to a participants’

fund. As an agent, the shareholders of the Takaful operator company donate to a

shareholders’ fund which is maintained separately from the participants’ fund. The Takaful

operator invests the participants’ fund in Shari’ah-compliant instruments in its capacity as

wakil or agent. All operational general and administrative expenses are charged to the

participants’ fund. The Takaful operator receives an agency fee from a percentage of the

gross contributions received. As valid claims are occurred, the benefits are paid to the

participants depending upon occurrence of actual losses and damages. Any underwriting

surplus is given back to the participants. And the participants are required to make additional

payment of deficit if any (Ibid).

Waqf Model. Under this model, a waqf can be established by the Takaful operator

through the contribution of a “ceding amount” (part of the capital) to compensate the

beneficiaries or participants of a Takaful scheme. The ceding amount of the waqf will remain

invested. The Takaful fund, consisting of the contributions paid as tabarru’, will be further

invested by the operator in accordance with Shari’ah. Any person by signing the proposal for,

contributing to the waqf and subscribing to the Takaful documents, shall become a member of

the waqf. The waqf will become owner of all contributions and has the right to act as a legal

14

entity as per its terms for investment, compensation and dealing with the surplus amounts.

The Takaful wakil, while managing the waqf fund, will play two different roles

simultaneously: operator/manager and trustee (Ibid).

Hybrid Model. The hybrid model combines elements of the wakalah and

mudharabah models and is set so that the Takaful operator has two funds; one for the

shareholders and the other for participants. In this model, a wakalah contract is used for

underwriting activities while mudharabah contract is used for investment activities. With

regard to underwriting activities, the Takaful operator acts as wakil or agent on behalf of

participants to manage their funds. In exchange for managing the funds, the Takaful operator

received a fee known a wakalah fee of agency fee which is normally a percentage of the

contributions by participants. An incentive fee is provided to the Takaful operator if there is a

surplus in the participants fund as a result of managing the fund effectively. Generally, any

surplus contributions will be invested in different Islamic instrument based on mudharabah

contract, which the Takaful operator acts as mudharib on behalf of participants (capital

provider). Like other mudharabah contract, the ratio of profit is fixed and agreed upon

between the two contracting parties (Ibid).

D. Malaysian Classifications

Takaful in Malaysia is broadly divided into Family and General Takaful.

Family Takaful Business. A Family Takaful plan is a combination of long-term

investment and a mutual financial assistance scheme. The objectives of this plan are as

follows:

To encourage saving on a regular basis over a fixed period of time.

To earn investment returns in accordance with Islamic principles.

To obtain coverage from a mutual aid scheme in the event of death of the

participant prior to maturity of the plan.

The contribution paid by the participant is credited into two separate accounts, namely the

Participants’ Special Account (PSA) and the Participants’ Account (PA). The portion of the

contribution that goes into the PSA is based on the tabarru’ or donation concept. The amount is

actuarially determined based on the age and overall health of the participant and the cover period.

The older the participant, the higher will be the portion of the tabarru’. Similarly, the longer the

period of coverage, the higher is the tabarru'. The balance of the contribution after deduction for

tabarru' goes into the PA account, which is meant for saving and investments only.

The participants' contribution that goes into the PSA will be used to fulfill the obligation

of mutual help should any of the participants face misfortune arising from death or permanent

disability. If the participant survives to the date of maturity of the Takaful plan, he or she will be

entitled to share the net surplus from the fund, if any. The fund in the PA account will be invested

by the Takaful operator. The profit from the investment will be shared between the participants

and the operator according to a pre-agreed ratio (Ibid).

General Takaful Business. The General Takaful scheme is essentially for mutual

financial assistance on a short- term basis, usually 12 months. The scheme is mainly to allow

participants to be compensated for any material loss, destruction or damage to their properties or

belongings by some mishap or misfortune. Under this concept, all the contributions made by the

participants are placed in the General Takaful fund on the basis of tabarru' or donation. This is

quite different from Family Takaful where the contributions of the participants are divided and

15

credited into two separate funds, the PSA and the PA. If at the end of the Takaful period, a net

surplus exists in the General Takaful fund, the same shall be shared between the participants and

the operator on the basis of mudharabah (profit sharing), provided the participants have not made

claims or received benefits in excess of contributions. The main types of General Takaful scheme

provided operators are:

1. Home Takaful scheme.

2. Motor Takaful scheme.

3. Marine, aviation and transit Takaful schemes.

4. Accident /miscellaneous Takaful scheme, which includes:

(a) Personal accident scheme.

(b) Workmen compensation Takaful scheme.

(c) Engineering Takaful scheme (Ibid).

E. Taxation in Malaysia

It should also be noted that in Takaful, zakat should be paid on any surplus; regardless

of whether the fund is otherwise subject to income taxes. Generally, companies are taxed in

Malaysia as residents, if the management and control of the company is based in Malaysia.

Control, for tax purposes, is demonstrated by the holding of statutory board meetings in

Malaysia which concern management and control of the company. Resident companies with

paid-up capital of RM 2.5 million or less are taxes at a flat 20% rate for the first RM500,000

of chargeable income and a flat 25% rate for chargeable income in excess thereof (PWC

2012).

Non-resident companies are taxed at a flat 10% rate on royalties, rental income on

moveable properties and technical or management service fees rendered in Malaysia. A 15%

rate applies to interest income that is not exempt. Interest income is exempt if paid by a bank

or finance company in Malaysia or paid on loans granted or guaranteed by the government of

Malaysia. Single tier dividends are exempt from tax, while other dividends are taxed at 25%,

as is business income. All other income is taxes at a flat 10% rate. Tax on income taxed by a

foreign country may be reduced. Non-resident income and related taxation may be subject to

any number of tax treaties (Ibid).

Dividends paid, credited or distributed by cooperative societies to their members are

exempt from taxation. A co-operative society must be registered. Co-operative societies are

not exempt from taxation themselves. 2012 legislation exempts interest income on co-

operative society deposit balances of up to RM100,000. Moreover, there are limited

deductions and exemptions from taxation, in addition to the incentive noted below, as

follows:

• A deduction up to a maximum of 25% of net income for contribution to statutory

reserve fund required to be created under the Cooperative Society Ordinance (Public

Ruling No. 9/2011 limits this deduction for additions to reserves to 25% of audited

net profits for the year).

• An amount equal to 8% of the members' funds (Public Ruling No. 9/2011 limits this

amount to 8% of the member funds at the beginning of the year and further defines

what balances are included in the term “member funds”).

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• Tax exemption for a period of 5 years from the date of registration is allowed to

enable new cooperative societies to establish themselves during the initial stage of

establishment.

• After the 5th years, cooperatives having members’ fund of RM750,000 or less will

continue to be tax exempted (Laws of Malaysia, Act 533).

Moreover, the primary incentive given to Takaful operators in Malaysia, is that of

exempting them from taxation for the years ending 2007 through 2016, for all income from

Takaful operations conducted in international currencies, provided the Takaful company or

unit is licensed under the Takaful Act of 1984. There is also an exemption from stamp duties

for co-operative societies for tax years beginning 2012 if the transaction being stamped is in

compliance with the Shair’ah. Finally, any company designated a Kuala Lumpur

International Finance Centre company, is exempt from taxation for a 10 year period and

exempt from stamp duties for loans done therein.

The Co-operative Society Act of 1993 (the Act), Part II, Section 4 defines a co-

operative society as:

“A society which consists of individual persons only and which has as its object

the promotion of the economic interest of its members in accordance with co-

operative principles may be registered under this Act as a primary society.”

(Laws of Malaysia, Act 502).

A society that consists of two or more primary societies only and whose purpose is

the facilitation of the purposes of the primary societies may be registered as a secondary

society. Similarly, a tertiary society is one that consists solely of two or more secondary

societies. A primary society must consist of at least 100 qualified individual members.

Exception for certain smaller co-operatives may be granted upon approval. The Act

specifically states that one of its purposes is “to encourage and promote the establishment and

development of co-operative societies in all sectors of the economy and to help co-operative

societies increase their efficiency.” Cooperative societies are specifically referenced in the

Takaful Act of 1984 as a mode of operation (Laws of Malaysia, Act 502).

According to the Malaysia Co-operative Societies Commission:

“The cooperatives with financial and banking functions have pioneered the

development of cooperative movement since the 1920s. These cooperatives

conduct financial activities such as providing loans to members at reasonable

interest rates. Other activities under this function are Islamic mortgage (Ar-

Rahnu), investment and insurance services. The members comprise those with

regular salary income, especially in the public sector, statutory and private bodies.

Currently there are two specific cooperatives which are carrying out banking

functions, namely Bank Kerjasama Rakyat Malaysia Berhad and Bank Persatuan

Malaysia Berhad.” www.skm.gov.my.

IV. REGULATORY OVERSIGHT & STANDARD SETTING

A. Legislative History

Malaysia’s Takaful Act 1984 is presently the world’s only specifically enacted

legislation governing the operation of Takaful funds. The laws governing Takaful vary from

17

one country to another. In other countries Takaful is subject to the existing laws applicable to

the insurance industry. Malaysia’s legislation recognizes Takaful as possessing unique

characteristics which justify an independent regulatory framework. One of the important

features of the Takaful Act 1984, which is not provided in conventional insurance, is the

requirement for the establishment of Shari’ah supervision.

In order to ensure compliance with Shari’ah principles, the Takaful operators are

required to observe the following at the company, as well as national, level:

The requirement to set up a Shari’ah supervisory board or Shari’ah committee within

the company, which advises the management to ensure that their activities fully

comply with Shari’ah principles.

At the national level, the National Shari’ah Advisory Council on Islamic Banking and

Takaful was set up at Bank Negara Malaysia (BNM) to advise on the Shari’ah aspects

of the operations as well as approval of various products and services.

The Takaful Act 1984 can be divided into four parts:

Part I: This provides for the interpretation, classification and references to Takaful

undertakings. Takaful is divided into two broad categories, namely General Takaful and

Family Takaful. Those who enter the plans are called Takaful participants, as opposed to

participants.

Part II: This provides the mode and conduct of Takaful undertakings, e.g. restriction

on the usage of the word “Takaful,” conditions of registration, restrictions on Takaful

operators, the establishment and maintenance of Takaful funds and allocation of surplus, the

establishment and maintenance of a Takaful guarantee scheme fund, requirements relating to

Takaful, and other miscellaneous requirements on the product of Takaful business.

Part III: This part specifies the powers vested in BNM and the appointment of its

Governor as the Director-General of Takaful in regulating Takaful undertakings, the powers

of investigation of BNM and provisions for the winding-up and transfer of business of a

Takaful operator.

Part IV: This provides for the administration and enforcement of matters such as

indemnity, submission of annual reports and statistical returns, offences and prosecution of

offences.

The Takaful Act 1984 was adapted from the Insurance Act 1963 and sections of that

Act were deemed non-Shari’ah complaint and were deleted; others were altered to comply

with Shari’ah requirements. The Insurance Act 1963 was subsequently repealed and replaced

with the Insurance Act 1996.

Under the Takaful Act 1984, a Takaful operator must be incorporated as a company as

defined in the Companies Act 1965 or as a society as registered under the Co-operative

Societies Act. The operator must have the required deposit and pay annual registration fees.

Moreover, it must maintain at all times surplus of assets over liabilities of not less than the

amount as may be prescribed from time to time. The Act requires that the objectives and

operations of the Takaful business must adhere to the tenets of the Shari’ah and must not mix

its operations with any prohibited activity under the Shari’ah.

B. Bank Negara Malaysia (BNM)

BNM, in order to spur the growth of Takaful, has forged certain guidelines. They

revolved around capital adequacy, financial reporting, anti-money laundering and prudential

18

limits and standards. It has elaborated and researched various issues which are faced by

Takaful companies and has issued guidelines to facilitate the operation of Takaful funds.

Some of these guidelines are:

Guidelines on Directorship for Takaful Operators

Guidelines on Prohibitions against unfair practices in Takaful Business

Guidelines on Claims Settlement Practices

Guidelines on proper advice for Family Takaful

Guidelines on Operating Costs of Family Takaful.

Source: Bank Negara Malaysia’s Shari’ah Governance Framework

Finally, BNM, in October 2010, implemented a Shari’ah Governance Framework

(SGF) that requires all Islamic financial institutions, including Takaful funds, to establish a

SGF. In addition to the Shari’ah advisory board requirement noted above, Takaful funds are

required to either employ internally, or to contract with external Shari’ah advisory firms that

will deliver a Shari’ah: (1) risk management control function; (2) review function; (3)

research function; and (4) audit function. Figure 1 illustrates the SGF.

19

Of particular note in the SGF is the critical role of the Shair’ah Audit and Review

functions. BNM defines a “Shair’ah Audit” as:

“Shariah audit refers to the periodical assessment conducted from time to time, to

provide an independent assessment and objective assurance designed to add value

and improve the degree of compliance in relation to the IFI’s business operations,

with the main objective of ensuring a sound and effective internal control system

for Shariah compliance.” (BNM 2010).

The Accounting and Auditing Organization for Islamic Financial Institutions

(AAOIFI) defines the “Shari’ah Review” function as:

“The primary objective of the internal Shariah review (carried out by independent

division or part of internal audit department) is to ensure that the management of

an IFI discharge their responsibilities in relation to the implementation of the

Shariah rules and principles as determined by the IFI’s Shariah Supervisory

Board (SSB).” (AAOIFI, Governance Standard for IFI No.3).

C. Islamic Financial Services Board (IFSB)

In 2006 the IFSB and IAIS wrote a paper titled “Issues in Regulation and Supervision

of Takaful” which deals with the application of the IAIS core principles needed to

accommodate Takaful such as corporate governance, financial and prudential regulations,

transparency, report and market conduct and supervisory review process.

In November 2009, the IFSB issued the “Guiding Principles on Governance for

Takaful Undertakings.” In December 2009, it issued IFSB-11, entitled “Standard on

Solvency Requirements for Takaful Undertakings,” which establishes solvency rules for

Takaful operators consistent with Solvency II (ISRA 2011). The main objective of this

standard is to emphasize capital adequacy and give confidence in the sustainability of the

Takaful market.

There are other relevant standards, such as: “Guiding Principles on Conduct of

Business for Institutions offering Islamic Financial Services,” “Guiding Principles on

Shari’ah Governance Systems for Institutions Offering Islamic Financial Services,” and a

“Guidance Note on the Recognition of Ratings by External Credit Assessment Institutions on

Takaful and Retakaful Undertakings” which buttress and underpin the growth of Takaful

throughout the world. Recently, the IFSB issued its Exposure Draft on Standard for “Risk

Management for Takaful (Islamic Insurance) Undertakings” (IFSB 2012).

D. Accounting Association of Islamic Financial Institutions (AAOIFI)

AAOIFI since its inception in 1991 has issued 81 standards, in which 4 standards are

related to Takaful (Shahul 2009). They are as follows:

1) FAS 12- General Presentation and Disclosure in the Financial Statements of Islamic

Insurance Companies. Basically, it deals with the following components:

Complete set of financial statements, including statement of participants’ surplus (or

deficit), and sources and uses of Zakah and charity funds;

General disclosures including those on earnings or expenditure prohibited by

Shari’ah; and

Treatment of changes in accounting policies, changes in accounting estimates etc.

20

2) FAS 13- Disclosure of Bases for Determining and Allocating Surplus or Deficit in

Islamic Insurance Companies. It has the following components:

General disclosures on contractual relationship between participants and insurance

operations manager;

Disclosure on accounting policies regarding the party that meets general and

administrative expenses; and

Disclosures on allocation of profit generated from investment of participants’ funds;

and on treatment of current deficit and/or cumulative deficit.

3) FAS 15- Provisions and Reserves in Islamic Insurance Companies. It contains:

Accounting rules for technical provisions such as unearned contributions provisions,

outstanding claims, and claims incurred but not reported;

Accounting rules for deficit reserves and equalization reserves; and

Recognition, measurement, and presentation of those provisions and reserves; and

disclosures on basis for determining provisions and reserves.

4) FAS 19- Contributions in Islamic Insurance Companies. It provides for:

Recognition, measurement, and presentation for contributions made on the basis of

donation by participants;

Disclosure on accounting policies for treatment of contributions;

Disclosure on accounting policies for withdrawal of policyholder and cancellation of

insurance policy; and

Presentation of Statement of Participants Revenue and Expenses.

Furthermore, all standards are reviewed. Review is to take into account, amongst

others, current market practices, prevailing conventional international standards, and

international best practices. And the review is to be carried out in consultation with the

industry experts.

E. Role of Shari’ah Boards & Committees

The general responsibilities of a Shari’ah Board or Committee are as follows:

Ensuring that both the shareholders’ and Takaful funds are handled and administered

in accordance with the Shari’ah tenets;

Catering expertise and guidance for the company in all matters pertaining to the

Shari’ah principles, its structure and investment process, and other operational and

administrative issues;

Consulting the authorities who may consult their Shari’ah Advisory Council where

there is any ambiguity regarding to investment, instrument, system, procedure and

process;

Scrutinising the company’s compliance report as provided by the compliance officer,

transaction report provided by or duly approved by the trustee and any other report

deemed necessary for the purpose of ensuring that the investments are compatible

with the Shari’ah precepts;

Preparing a report to be included in the company’s annual report certifying whether

the Takaful business has managed in accordance with the Shari’ah principles;

To make sure that the Takaful undertaking complies with any guideline, ruling or

decision issued by the authorities with regard to Shari’ah matters;

21

Vetting and advising on the promotional materials of the company; and

Assisting and attending to any ad-hoc meeting called by the authorities or any other

relevant authority (CIFP, op.cit.).

F. Fatawah

The first fatwa prohibiting conventional insurance in its modern form was rendered by

Ibn Abdeen, a Syrian scholar in 1834 (Khan 2008). As noted earlier, the modern prohibition

began in Saudi Arabia (1977), followed by fatawah in numerous Islamic countries, including

Malaysia (1982). Since then, there have been numerous fatawah or Shari’ah rulings on the

various practices surrounding Takaful (some of which are referred to as resolutions, when

issued by Shari’ah boards or committees). Resolutions do not carry the same legal strength as

fatawah, but for purposes of this paper, they are grouped under that heading for illustration

purposes only. Figure 2 list the primary sources of them.

Figure 2

• 19 wide ranging “Resolutions” pertaining to Takaful, including Takaful Models, Takaful coverage for conventional Loans, Segregation of Takaful funds, distribution of surplus from the PSAs, provision of reserves, etc.

Bank Negara Malaysia’s

SAC

• 15 Fatawah with respect to Takaful, including health & medical plans, auto insurance, protection against vandalism, insurance of debt, insurance on cash balances, insurance on investments, etc.

Kuwait Finance House

• Fatawah on health insurance, various aspect of insurance and use of reinsurance in the absence of retakaful operators.

OIC FiqhAcademy

Summary of Fatawah on Takaful and Retakaful summarized from www.isra.my

V. RISK ATTRIBUTES OF TAKAFUL

A. Risk Profile. Takaful, though socio-religious in its epistemology, is

nonetheless in the “business” of identifying, measuring & managing risks through avoidance

& transference techniques. Some risks are endemic to Takaful, e.g. the reputational risk

associated with Shari’ah compliance. Other risks are entity or firm level, e.g. those that might

be affected by the underwriting classes of a particular Takaful undertaking. Other risks are

systemic and affect the entire insurance industry. Some authors classify Takaful risks as

either “pure” or “speculative.” Pure risks, according to them, are those risks that have only 2

possible outcomes, i.e. loss or no loss and there is no possibly of gain. Speculative risks, they

aver, are those in which the uncertainty about the risky event could result in either gain or

loss (Obaidullah 2005).

22

Such taxonomies remind us that Takaful undertakings are inherently risky and that

risk of loss is ever imminent. Almighty Allah reminds us of the inevitability of (risk) by

identifying two forms of disaster (museebah):

“And we shall surely test you with something of…loss of wealth and lives…but

give good tidings to the patient, who when disaster (museebah) strikes them, say,

‘indeed we belong to Allah, and indeed to Him we will return.’” (2:156-57).

Malaysia does have a better risk profile than other ASEAN nations when it comes to

natural disasters; being identified as high risk only in the area of floods (ASEAN 2011). And

at the moment anyway, Southeast Asia is less volatile politically than the Middle East and

North Africa (MENA) region. Yet, some risks simply are virtually unmanageable. In a world

marked by terrorism, ideological conflict, war, natural disasters, political unrest, ecological

disasters and technological errors, now, possibly more than ever before, the single most

dangerous risk is pure risk.

However daunting the task, Takaful, like its counterpart, insurance, must classify its

risks. The IFSB, which is based in Malaysia, is presently grappling with this very issue. As

noted earlier, the IFSB recently (November 2012) issued its Exposure Draft on “Risk

Management for Takaful Undertakings.” The taxonomy of Takaful risks is presented therein

as follows:

1. Reputational and Regulatory Risks associated with Shari’ah non-compliance,

caused by-

Breach of Shari’ah principles in its contracts

Differences in perceptions of Shari’ah compliance emanating from varying

interpretation of Fiqh Muamulat by Shari’ah scholars and differences in jurisdictional

practices worldwide

Increased competition and pressure to develop innovative products that are non-

compliant

Limited availability of Shari’ah-compliant investment instruments could lead to

questionable practices

Separation of participant funds (both risk and investment designated) and shareholder

funds in the mudharabah and yadd damman models and the concomitant agency risks

and vigilance in the areas of fairness and transparency

Inability to mitigate risks through diversification between stakeholder funds can result

in higher economic capital requirements

Qard mechanisms and risks associated with the requirement to make these loans to

participants, as well as the risk associated with their inability to repay them

Mis-segregation and mis-allocation of income and expenses between stakeholders

Misaligned underwriting costs and expenses resulting in the inability to meet the

requirements of the underlying contracts

Reinsurance and other risk transfer difficulties associated with excess exposure

concentrations or connected counterparties

Risks associated with the both the polemics over the legitimacy of using reinsurance

vis-à-vis retakaful, as well as the attribution of funds under both, e.g. the payment of

commissions as opposed to actual risk sharing arrangements

23

Credit risk exposure from retakaful contracts and the quality of risk selection and

pricing, requiring due diligence and good governance

2. Specific Risks of Particular Relevance to Takaful-

A. Operational risk or the risk of loss resulting from inadequate or failed internal

controls, people or systems; or from external events. It may also include the Shari’ah

risk of operators failing to meet their fiduciary duties. These risks may result in:

An inability to pursue opportunities, inefficiency and threaten business continuity

Breach of fiduciary duties

Underwriting “management” risk or failure to properly managed the contributions by

participants

Negligent, incompetent, fraudulent or criminal activities

Failure of information technology systems

Failure to be vigilant in monitoring outsourced activities, particularly as related to

Shari’ah norms and prohibitions

B. Underwriting risk is the risk of loss due to underwriting activities, including

assumptions used in pricing and assessment, later found to be incorrect, and may result in-

Failure to identify changes in expected and actual claims experience, including

mortality and morbidity, so as to acknowledge trends in claims and settlement costs

and needed changes in underwriting standards, policy provisions and pricing.

Faulty expense assumptions, including remuneration.

Increased lapses in policies and lack of persistency in renewals and new participant

contributions, all of which may affect risk pool volatility.

Monitor deficiencies or failures to collect on Qard, which may be linked to

perceptions of poor underwriting management; unlike conventional insurers, Takaful

funds can only repay these losses out of future surpluses and not new contributions.

Unacceptable concentration risk levels related from positive correlations between risk

pools underwritten and failure to transfer such risks to Retakaful plans.

Increased provisioning risk, which relates to level of reserves to meet future claims

and claims being processed.

Increased provisioning risk caused by failure to properly project losses by

underwriting and loss year and failure to reassess projection methods periodically.

Misperceptions created in the minds of participants as to minimum levels of returns

on Family investments or surplus distributions (participant reasonable expectations)

Mis-management of co-Takaful arrangements and under provisioning of related

claims.

C. Market risk is the risk of losses arising from movements in market prices, i.e.

fluctuations in values of leases, sukuk and other investments and deviation of actual returns

from expected returns. This risk may lead to-

Deficits in reserves and inadequate performance.

Failure to adopt investment strategies by investment instrument that quantify the

impact of fluctuations and are based on the ability to absorb fluctuations.

Failure to hedge in order to dampen such fluctuations by asset class.

24

Failure to align asset-liability management to create cross-subsidy between funds

being managed by one Takaful operation.

D. Credit risk is the risk that a counterparty fails to meet its obligations, resulting in

misalignment of operational, financing and investment activities, caused by-

Failure to provide for viable Retakaful relationships and to manage the provision of

coverage on General Takaful extended on a credit basis.

Failure to identify, measure and manage investment risks by asset class and fund

exposure.

Failure to manage Qard during growth periods or following major losses through

capital adequacy.

E. Liquidity risk is the risk of loss arising from an inability to meet impending

obligations or to fund increases in assets as they fall due without incurring unacceptable costs

or losses that may cause-

Inability to dispose of assets in an orderly manner, in time to cover claims or

withdrawals, or to pay debts in a timely manner; all of which may lead to the loss of

confidence, reputational damage, uncontrolled withdrawal, litigation or regulatory

action.

Inability to pay wakalah fees and to distribute surpluses.

Possible Qard drawdowns.

Inability to service debts related to PP&E acquisitions, fees for underwriting, etc.

Failure to implement, monitor and manage liquidity policies, including the failure to

plan for and have contingency plans to address shortages in internal and external

financing sources.

F. Legal and Compliance risk is related to the legal and regulatory implications of

operational activities, disputes and contractual difficulties, which may cause-

Unethical behavior, including poor handling of agency conflicts.

Failure to reconcile conflicting interests pursuant to IFSB-8.

Non-compliance with jurisdictional laws and regulations, which may be the result of

the failure to implement compliance review procedures.

Criminal activity, fraud and breach of international sanctions; all of which may

damage the reputational risk of the Takaful fund (IFSB Exposure Draft No. 14).

B. Risk Intermediation.

Underwriting is the traditional tool used in insurance risk intermediation. It is defined

by the International Insurance Institute as “(e)xamining, accepting, or rejecting insurance

risks and classifying the ones that are accepted, in order to charge appropriate premiums for

them.” Takaful operators adapt the underwriting process to determine contribution rate (in

lieu of premiums) using three stages:

Gathering Information;

Classifying risks, e.g. preferred, standard, rated, postponed or declined in life policies;

and

Determination of a contribution rate (Alhabshi op.cit).

The recent IFSB Exposure Draft-14 indicates that a risk management framework

(RMF) should be established, which is comprehensive in nature, contains a set of consistently

25

applied policies and strategies and encompasses the Takaful’s appetite for risk, its processes

for managing them and the governance thereof. The policies typically address the issues of

risk retention, retakaful, Shari’ah-compliant hedging techniques and regulatory capital

adequacy requirements. Emphasis is given to the process of identifying as many foreseeable

risks as possible with an eye towards new and emerging risks. In addition to risk policies and

strategies, the RMF should contain a risk register, as well as risk identification processes and

risk assessment, response and control procedures.

The Exposure Draft further recommends an internal control framework covering the

key activities of the Takaful, encompassing risk detection and prevention controls of either a

manual or automated nature. Takaful undertakings are further advised to establish risk

monitoring information systems with comprehensive reporting capabilities. These controls

should be embedded in daily operations (1st line of defense), independent monitoring, the

review of the risk management mechanism (2nd

line of defense) and an independent assurance

or audit function (3rd

line of defense).

Finally, the RMF should have an asset-liability management (ALM) functionality,

which monitors assets and liabilities for mis-matches, divergence of actual and expected

levels of returns, misaligned risk-returns, liquidity requirements and embedded options in

contracts, e.g. settlement options, policy loan options, over-depositing options and surrender

or renewal privileges (all of which could result in additional costs). External factors and

changes in business composition and direction should also be considered (IFSB op cit).

Given Malaysia’s leadership in regulatory oversight in the Takaful and Islamic

Finance arenas, as well as its strong alliance with the IFSB, Malaysia is strategically

positioned to continue to play a leadership role in the global Takaful market. That said, what

will continue to be her greatest challenge will be to manage the risks inherent in Takaful,

while adhering to the social principles upon which Takaful is founded. One such challenge

will be to devise innovative ways to make Takaful affordable to the widest possible number

of her citizenry.

C. Retakaful

Takaful operators may transfer risks to larger operators. This is generically called

reinsurance, or retakaful in Islamic Finance. Reinsurance is defined as: “Insurance bought by

insurers. A reinsurer assumes part of the risk and part of the premium originally taken by the

insurer, known as the primary company. Reinsurance effectively increases an insurer's capital

and therefore its capacity to sell more coverage. It also allows Takaful funds to shift or

transfer their larger risks to these companies, who accept these risks from a diversified list of

primary companies; thus, spreading the risk through their auspices, which could not

otherwise be intermediated by a single Takaful operator. The retakaful is global and some

of the largest reinsurers are based abroad. However, Malaysia is home to 2 of these large

retakaful operator’s subsidiaries, i.e. Munich Retakaful and Swiss Re.

Reinsurers have their own reinsurers, called retrocessionaires. Reinsurers don’t pay

policyholder claims. Instead, they reimburse insurers for claims paid. They do so under 2

methods:

• Facultative. A reinsurance policy that provides an insurer with coverage for specific

individual risks that are unusual or so large that they aren’t covered in the insurance

company’s reinsurance treaties. Examples are coverage for jumbo jets or oil rigs.

26

• Treaty reinsurance. A reinsurer agrees to assume a certain percentage of an entire classes

of business, e.g. as various kinds of general Takaful, up to preset limits.

Retakful operations are structured on the tabarru’ basis. They take contributions from

participating Takaful operators, who share in the risk pools. Retakaful operators primarily use

the wakalah and mudharabah models. The wakalah fee is usually paid up front and runs

approximately 5% for acting as wakil over the pooled fund. The mudharabah shares in the

profit from managing the investments of the pooled fund as the mudharib partner. The profit

percentage may vary but ARC, for example, charges 40%7.

Malaysian Takaful operators, on average, ceded about 20% of their commissions to

retakaful in 2011. That compares with roughly 34% in the GCC. The disparity is explained

by operators as being due to the GCC Takaful concentration in General Takaful vis-à-vis their

Malaysian counterparts (Ernst & Young 2012). Retakaful operators in Malaysia provide Qard

facilities to the Takaful participants in their funds.

There exists a shortage of retakaful operators worldwide; although it is less of

problem in Malaysia because of the presence of 4 retakaful operators. This has resulted in

some discussion over the permissibility of using reinsurance in lieu of retakful. This issue

was largely resolved when the OIC Fiqh Academy in its 1985 fatwah, stating: “The Council

encourages Muslim countries to establish cooperative insurance and reinsurance institutions.

This is so that Islamic economics would be liberated from exploitations and violations of the

system that Allah has chosen for this ummah.” Accordingly, absent an apparent weakness in a

retakaful or mutual or cooperative reinsurance company, e.g. failure to meet capital adequacy

requirements, etc., if there is a need to turn to the reinsurance market, the Takaful operator

should first try and obtain coverage from the retakaful, cooperative or mutual insurance

sector (Ismail 2009).

D. TIPS

Malaysia has a Takaful and insurance benefits protection system (“TIPS”) as a limited

protection system to cover both Takaful and insurance benefits. TIPS the acronym for

Perbadanan Insurans Deposit Malaysia (“PIDM”), an independent statutory body established

under the Malaysia Deposit Insurance Corporation Act 2011 (Act). Its stated purposes are to:

• Administer a deposit insurance system and a Takaful and insurance benefits

protection system under the Act;

• Provide insurance against the loss of part or all of deposits for which a deposit taking

member is liable and provide protection against the loss of part or all of Takaful or

insurance benefits for which an insurer member is liable;

• Provide incentives for sound risk management in the financial system; and

• Promote or contribute to the stability of the financial system.

PIDM collects premiums from member Takaful and insurance companies. The premium rates

are determined actuarially by the Malaysia Deposit Insurance Corporation (MDIC). TIPS

manages and segregates different funds into pools, as follows:

• Family solidarity Takaful protection fund;

• General Takaful protection fund;

• Life insurance protection fund; and

Model/-Operational-Us/Retakaful-http://www.acrretakaful.com/en/SEA/About

7

27

• General insurance protection fund.

There is no comingling of incomes or expenses between any of TIPS funds. There are limits

on the coverage provided by TIPS. The schedule of coverage benefits can be viewed at

http://www.pidm.gov.my/downloads/guide_TIPS_RCP.pdf.

VI FINANCIAL ATTRIBUTES OF TAKAFUL

A. Financial Intermediation

One of the common features Takaful shares with conventional insurance is the role it

plays in financial intermediation. “Financial intermediation is a productive activity in which

an institutional unit incurs liabilities on its own account for the purpose of acquiring financial

assets by engaging in financial transactions on the market; the role of financial intermediaries

is to channel funds from lenders to borrowers by intermediating between them.” (Retrieved

from http://esa.un.org/unsd/sna1993/introduction.asp).

While the above definition may be more suited for conventional insurance providers,

its application to Takaful, once modified, still applies; notwithstanding Takaful’s motivation

of mutual protection and shared responsibility. (Engku Ali 2008). In short, modern financial

exigencies give Takaful little choice but to incur a liability (notwithstanding the charitable

donation character of participant contributions) on behalf of its participants, by collecting

contributions from them, and in turn, investing the net of those proceeds in a Shari’ah-

compliant manner in the marketplace in anticipation of fulfilling the future obligations to its

members. This is the essence of the economic activity known as the “intermediation effect”

(Smith 1978), or simply put, financial intermediation.

Insurance has been causally connected to economic growth in developed countries

and anecdotally believed to be an economic driver in others through job creation, risk

intermediation, etc. Studies have shown that it positively contributes to economic

development through financial intermediation in the financial market, particularly the long-

term investment market (Brainard 2008). That is attributable to the inherent need of insurance

carriers to “match” longer term obligations with longer term, relatively stable investments.

Data shows that through its investment intervention in the market, Takaful provides a

fairly steady source of liquidity. Put differently, Takaful is a source of funds, i.e.

contributions from its members or participants. Those funds quickly find their way into the

financial market after payment of concomitant expenses, e.g. commissions, overhead and

claims as they become due and payable. Those funds are invested with firms and government

as a significant source of liquidity. From the Takaful operator’s viewpoint, these investments

produce both income (from profits and dividends), capital gains from the sale of those

investments and other cash flows; all of which represent the cash inflows of the Takaful fund.

These aggregate funds inflows contribute to the overall well-being of the financial sector of

Malaysia and her economy.

The size of these inflows in Malaysia over the past nine (9) years, i.e. from 2003

through 2011 can be seen in Table 2. As can be seen from Table 2, Family Takaful net

contributions provide the “lion’s share” of the liquidity at 76.2% of contributions; while

Family inflows represent 60.9% of the total cash inflows from Takaful undertakings at

December 31, 2011. Net Family contributions grew 9.2% in 2011. Net contributions are net

28

of any brokerage commissions that might result in double counting. Net contributions are also

net of contributions paid for retakaful.

However, it should be apparent that General Takaful inflows have grown dramatically

over the 9 year period, i.e. a total of 413% or an average of 45.9% per year. Its contributions

have grown an average of 51.2% per year over the past 9 years. General contributions grew

12.4% in 2011. Obviously, both lines experienced slower growth in 2011. However,

preliminary numbers being reported for 2012 suggest growth may return to the higher levels.

Table 2

(In RM millions) 2003 2004 2005 2006 2007 2008 2009 2010 2011

Net Investment Income:

Family 165.3 156.6 192.3 232.0 284.5 298.8 354.8 447.3 501.3

General 21.5 14.7 19.6 32.3 44.6 50.6 57.7 68.4 84.5

Total Net Investment Income 186.8 171.3 211.9 264.3 329.1 349.4 412.5 515.7 585.8

Sale of Assets & Other Income:

Family 41.2 77.5 69.5 123.4 111.8 164.9 307.1 336.4 647.5

General 8.9 108.3 68.3 78.5 62.7 92.0 79.2 90.4 156.2

Total Other Income 50.1 185.8 137.8 201.9 174.5 256.9 386.3 426.8 803.7

Net Contributions:

Family 762.5 794.4 977.1 1,242.3 1,988.5 2,372.9 2,718.1 3,391.1 3,703.6

General 251.5 328.7 356.6 479.2 576.5 652.2 803.7 1,030.7 1,158.9

Total Net Contributions 1,014.0 1,123.1 1,333.7 1,721.5 2,565.0 3,025.1 3,521.8 4,421.8 4,862.5

General Reserves & Write-Backs

326.0 375.4 558.8 662.3 849.7 1,032.3 1,167.2 1,394.4 1,717.2

Total Cash Inflow:

Family 969.0 1,028.5 1,238.9 1,597.7 2,384.8 2,836.6 3,380.0 4,174.8 4,852.4

General 607.9 827.1 1,003.3 1,252.3 1,533.5 1,827.1 2,107.8 2,583.9 3,116.8

Total Cash Inflows 1,576.9 1,855.6 2,242.2 2,850.0 3,918.3 4,663.7 5,487.8 6,758.7 7,969.2

Adapted from BNM 2011 Statistical Reports

Table 3 shows the asset holdings of Takaful in Malaysia from 2003 – 2011, along

with the respective percentage of those holdings. Family Takaful assets comprise 84.8% of

total Takaful assets in Malaysia. Almost 98% of Takaful’s RM16.9 billion in assets at year

end 2011were invested in the Malaysian Islamic Capital Market, either directly or indirectly.

As can be seen from Figure 3, Takaful provides significant financial intermediation to the

Islamic Capital Market in Malaysia with 21% of its investment assets in Government Islamic

Paper (GII), 73.4% of those assets were in Shari’ah-compliant private debt and equity

instruments and 5.6% of its directly invested assets in other instruments. Although the BNM

reports do not disclose the debt or equity breakdown of Takaful fund capital market activity,

Ernst &Young 2012 World Takaful Report, sampled Malaysian Takaful operators, indicated

an allocation of 20% equity and 57% Sukuk; with 20% in depository accounts and roughly

3% in real estate. Those amounts approximate the amounts in Table 3. The corresponding

29

Malaysian debt/equity Islamic Capital Market investment would then approximate RM5.2

billion and RM1.83 billion, respectively.

Table 3

RM Millions and % Family General Total %

Fixed Asset 0.9 0.0 0.9 0.0%

Investment Properties 306.0 26.6 332.6 2.0%

Financing 42.3 0.9 43.2 0.3%

Gov't Islamic Paper (GII) 2,231.1 380.4 2,611.5 15.4%

Islamic Private Debt & Equities 7,935.2 1,196.9 9,132.1 53.9%

Other Investments 637.3 64.8 702.1 4.1%

Foreign Assets 8.6 0.0 8.6 0.1%

Investment Accts & Money Market 2,669.0 601.2 3,270.2 19.3%

Cash & Bank Balances 143.2 37.3 180.5 1.1%

Other Assets 404.6 261.8 666.4 3.9%

Total Investment 14,378.2 2,569.9 16,948.1 100.0%

Adapted from BNM 2011 Statistical Reports

As noted earlier in this paper, Malaysia has 8 Takaful operators. The majority (6) have

affiliation with banks or international financial firms. The 2 original Takaful funds are the

exceptions, i.e. Ikhlas and Takaful Malaysia. All Takaful operators have investment linked

funds; generally growth, income, fixed or balanced. The actual investment mix for Takaful

funds varies. Review of Takaful financial statements reveal investment mixes approximating

the breakdown between government Islamic securities, private Islamic debt and equities and

depository accounts discussed herein above. All Takaful and Retakaful operators in Malaysia

are required to have a investment policies that reflect the reasonable expectations of their

participants pursuant to BNM “Guidelines on Investment Management for Takaful

Operators.”

Figure 3

December 2011

Adapted from BNM 2011 Annual Report

2,611.5

9,132.1

702.1

Takaful Investment Asset AllocationIn Millions RM

Gov't Islamic Paper (GII)

Islamic Private Debt & Equities

Other Investments

It is noteworthy to mention that Government Islamic Paper or GII is a controversial

Islamic security. They are trust certificates issued on the basis of bai’ al-inah, a method of

Islamic finance that is controversial, as it involves selling a financial product or other item to

a party for cash and buying it back at a higher price over time or immediately (a clear case of

riba absent an exemption). It is rejected by the Maliki and Hanbali mudhahib. It is deemed

permissible in the Shafi’ee madhab only; although it is permissible under the Hanafi madhab

if it involves a third party.

30

Thus, its acceptance, as practiced in Malaysia is a minority position. Imam Shafi’ee

preferred an unwillingness to read into the intention of the parties. In other words, he did not

look past the 4 corners of the operative agreement. Thus, whether or not the parties intended

at the point of the first part of the sale to resell the item back to the counter-party at a higher

price would not be investigated under the Shafi’ee approach. That does not seem to be likely

in the GII transaction, as it is clear that when the paper is issued, it is intended to be

repurchased by the government (although it is possible that the holder of the certificate might

seek to transfer it; thus meeting the Hanafi stipulation of it being acceptable if repurchased by

a third party). However, even in the case of the third party transfer, the rules governing the

tradability of debt must be observed.

Malaysia’s SAC, by Resolution, decided to accept the minority position as it is vital to

the needs of BNM to be able to access the liquidity market. Failure to do so would clearly

create a hardship for BNM and in turn the people of Malaysia. Also, when faced with the

choice, it is a legal maxim to choose the lesser of the two in harm. Thus, it is either bai’ inah

or conventional money market operations; bai’ inah being the clear choice in such a case.

Moreover, scholars in Malaysia have called into question the strength of the Hadith collected

by Abu Dawud, wherein he transmits: “If you sell to one another with inah, hold the tails of

cows (meaning then just go for the worldly gains and ignore your religion)…” (Al-Fawzaan

2005). That said, however, when there is no commodity involved, the exchange in bai’ al-

inah is purely monetary, subjecting it to the rules of bai’ as-sarf or spot transactions (money

being analogized by many scholars to gold or silver). (Ayub 2007).

Table 4

Return on Investments

RM Millions 2003 2004 2005 2006 2007 2008 2009 2010 2011

GII 426.7 597.4 662.2 732.6 778.0 855.8 1,296.1 2,255.7 2,611.5

Islamic

Debt/Equities

2,047.7 2,463.9 2,997.7 3,191.3 3,871.3 4,844.7 6,181.6 7,605.1 9,132.1

Other 9.9 5.3 59.2 63.7 305.3 394.0 543.5 678.1 702.1

Total

Investments

2,484.3 3,066.6 3,719.1 3,987.6 4,954.6 6,094.5 8,021.2 10,538.9 12,445.7

Returns 186.8 171.3 211.9 264.3 329.1 349.4 412.5 515.7 585.8

ROI-HPR 7.52% 6.17% 6.25% 6.86% 7.36% 6.32% 5.84% 5.56% 5.10%

Source: Adapted from BNM Annual Reports

Table 4 shows the annual returns on investments of Takaful funds in Malaysia. The

2011 return of all Takaful funds in Malaysia (5.1%) is slightly lower than the returns shown

in the E&Y sample for the same period, i.e. 6%. That same sample shows returns for 2007

through 2010 at 3%, 4%, 3% and 4% for those years respectively. As can be seen, the returns

for the same periods above show 7.36%, 6.32%, 5.84% and 5.56% respectively for the years

2007, 2008, 2009 and 2010. However, the sample in the 2011 sample, for example, only

included 3 Takaful respondents, while Malaysia had 8 Takaful operators in 2011. The

difference might be attributable to method of calculation. In Table 4, except for 2003, the

average investment (the current year plus the prior year divided by 2) is used as the

denominator in the calculation. In any event, geometric mean return over the 9 year period in

31

Table 4 is 6.29%, indicating that Malaysian returns are higher on average than those in the

GCC, which were 13%, -2%, -4%, 5% and 6% for the period 2007 through 2011 according to

the E&Y sample.

It is remarkable that in 2011, for example, conventional insurance returns on

investments were 12% based on the E&Y sample. If the results are representative of the

difference between the returns for conventional insurance vis-à-vis Takaful, this disparity

does not bode well for Takaful participants and operators. It is indicative of poorer

investment performance and will undoubtedly, if conventional wisdom serves well, impede

the growth and penetration of Takaful in the future.

B. Capital Structure

Cost structure. Table 5 is an approximation of the cost structure of Takaful in

Malaysia. An approximation is used since BNM reports do not “breakout” in detail certain

costs and do not include accrued unpaid benefits or claims in their “outflow” reports.

Nevertheless, the tabulated amounts give the reader an idea of the costs as a percentage of net

contributions, which appear comparable when using the E&Y 2011 Malaysian sample

amounts as benchmarks.

Table 5

Core Operating Costs & Ratio for Takaful

RM Millions

Source: Adapted from BNM Annual Takaful Reports

The comparable E&Y Malaysian sample amount for core operating ratio shows that

operating costs are 78% of contributions for 2011 for the sampled Malaysian Takaful

operators, while the above ratio is 75.9%. GCC core operating costs, by contrast, were 102%

of contributions, while conventional insurance companies in Malaysia had core operating

costs of 87% of their premium base. These amounts and ratios indicate that Malaysian

Takaful operations are likely more efficient. The 2011 data suggests that Malaysian Takaful

funds operate with an approximate operating margin of 24%.

Similarly, the comparable E&Y Malaysian sample shows a commission payment ratio

for the sampled Malaysian Takaful operators at 13% for 2011. The above ratio, though not

displayed for 2011, is approximately 15.6%, slightly higher. This could be due to method of

calculation, i.e. net versus gross contributions, as the ratio on the above numbers would be

13.5% if based on gross contributions (i.e. net contributions plus commissions), a total of

32

RM5,622.2. In any event, Malaysian conventional insurance commission payment ratio

shown in the E&Y report for 2011 is 14% or slightly higher. However, GCC Takaful

commission payment ratio is 4%, while the ratio in Saudi Arabia is 6%. According to the

E&Y report, these differences are perennial, though GCC ratios may increase as competition

stiffens there.

Finally, Table 5 shows that claims and benefits paid constitute roughly 45% of

Malaysian Takaful net contributions. This is in line with the E&Y report, though it shows the

ratios separately for Family (approximately 45%) and General (approximately 59%). Once

weighting and sample size are considered, the above ratio appears comparable and is likely

reasonable. Malaysian claims and benefits payment ratios have been perennially lower than

the GCC’s. Bahrain’s ratios are dropping and approaching those of Malaysia. No comparable

data was shown for Malaysian conventional insurance companies (although BNM reports

may carry the requisite amounts).

Cost of capital measures. Most Malaysian Takaful operators have bifurcated capital

structures, i.e. they use the Mudharabah or Hybrid models. Insurance firms use cost of capital

as a benchmark for premium charges, capital allocation and performance measurement

(Exley 2006). Traditional cost of capital models, e.g. CAPM and the modifications of

Modigliani and Miller, may not adequately depict cost of capital for insurance firms (where

the participants/participants are providers of capital). In Takaful undertakings, the expected

return of the participants is an important consideration; not just because of the investment

aspects of Family funds, but because the participants are real stakeholders in the fund.

Merton and Perold, in their seminal work, were among the first to identify insurance

companies as “principal financial firms” (Merton & Perold 1993). A principal financial firm

is one that acts as principal in the ordinary course of business. In the case of insurance, the

firm is liability-related, i.e. the underwriting of guarantees. Principal financial firms have 3

distinguishing features: (1) their customers (as opposed to investors) are “credit sensitive;”

(2) their opaqueness (reluctance to disclose details of their financials) causes them to have a

higher cost of risk capital; and (3) they have a high sensitivity of profitability to the cost of

risk capital (ibid).

Merton and Perold defined “risk capital” as “the smallest amount that can be

invested to insure the value of the firm’s net assets against a loss in value relative to the risk-

free investment of those net assets.” They defined “net assets” as “gross assets minus

customer liabilities (valued as if these liabilities are default-free).” The importance of Merton

and Perold’s analysis is that it brought attention to the fact that the cost of capital for

principal financial firms is complicated by the difficulty in assigning such a cost to customer

liabilities (Exley 2006). Little research appears to have been done for Takaful in the area.

Nevertheless, insurance companies still calculate cost of capital, risk capital and firm

valuation using the following methods:

• WACC or weighted average cost of capital (weighting debt as one of two risky assets

based upon expected rates), and deriving the equity portion of the computation using

the CAPM model (which requires knowledge of the firm’s beta, in addition to the

market rate of return and risk free rate of return). Aviva has been known to use this

method.

33

• Comparisons of returns to selected “hurdle” rates, e.g. RORAC. RORAC is calculated

by dividing the risk-weighted return by the economic capital. Risk-weighted return is

based on operating results, but credit risk adjustments are replaced by expected losses.

Economic capital is defined as Merton and Perold defined risk capital.

• Market Consistent Embedded Valuation (MCEV), which is a bottom up approach to

embedded value calculations; essentially the risk capital noted above. This approach

uses present value calculations, but applies separate discount rates for each cash flow

based upon the risk appropriate for the asset/liability being valued. Among the

liabilities, of course, are those relating to claims and benefits. It also adjusts

valuations with so-called “frictional costs,” some of which were identified in Merton

and Perold’s paper, e.g. agency costs, moral hazards, information costs, taxes, costs of

raising money, etc. Munich Re favors this method.

C. Growth Patterns

The development of a financial system is referred to in the literature as financial

“deepening.” Financial “deepening” and economic development are closely correlated

(Kiyotaki 2012). The financial sector in a society is by its very nature a subset of the culture

or society that gave genesis to it. A nation’s financial sector is not insulated from the

influences, history, axioms and culture of that nation. Culture influences the norms and

collective values of a society. These are axiomatic and empirical research substantiates them.

Seminal research by Hofstede (1984), Schwartz (1992) and Gray (1998) are instructive.

Malaysia’s financial system is influenced by its norms and values. An Islamic

financial system must be imbued with Islamic norms and values. That is not to say that

remnants of colonial and imperial domination do not exert tremendous “magnetic pull” on a

nascent Islamic financial system (Hasan 2010). Yet, there is, as stated in the Islamic Financial

Services Industry Development’s “Ten-Year Framework and Strategies,” a distinct “need for

a socially inclusive financial system.”

Among Asian nations, Malaysian culture is relatively rich in diversity, i.e. it is

comprised of several religious and racial groups. Takaful is indigenous to the Islamic ethos,

which is remarkable in Malaysia. And though it has been in this milieu that Takaful’s nascent

beginnings have taken root, from a domestic standpoint, this may also restrict that growth.

Though the growth so far has been steady, it may require that it extend its reach to the

broader society and global village, in order to “maximize” that growth.

Malaysia is no neophyte in integrating her Islamic products into the larger financial

system. She has been successful in integrating her Islamic banking system into the larger

conventional banking sector. She is now faced with the similar, yet distinguishable, task of

doing the same with Takaful. Banking and “insurance” are both financial products, but their

constituencies and drivers are not necessarily the same; even similar. The decision to invest

in “insurance,” after all, is a quintessential risk aversion decision; albeit all financial

intermediation is at some level risk avoidance, transference or management (Allen 1996).

Figure 4 shows the wide disparity in Malaysia between Takaful contributions and

conventional insurance premiums. Takaful is roughly 10% of the total “insurance business.”

The data does not appear to indicate any significant penetration overall. However, more

precise empirical testing would be needed to draw statistically relevant conclusions.

34

Nevertheless, Figure 4 does, at least, show that there is plenty of room for growth

domestically for Takaful, if the financial and marketing challenges can be met. For example,

Figure 4

Total Malaysian Premiums2003-2009

In Millions RMCompiled from BNM Reports & Int’l Ins. Inst. Fact Books

0.0

5,000.0

10,000.0

15,000.0

20,000.0

25,000.0

30,000.0

35,000.0

40,000.0

45,000.0

50,000.0

1 2 3 4 5 6 7 8 9

Total Malaysian Takaful Premiums 1,014. 1,123. 1,333. 1,721. 2,565. 3,025. 3,521. 4,421. 4,862.

Total Malaysian Premiums 21,314 24,521 27,462 27,660 30,531 31,085 31,374 37,925 43,244

Total Malaysian Takaful Premiums

Total Malaysian Premiums

Family Takaful should be closely correlated with demographics. Malaysia’s Muslim

population was 60.4% of its population (according to the 2000 census)8. That statistic would

appear to support a significant opportunity for growth among the Muslim population alone.

Moreover, if Takaful grows keeping both its technical and socio-religious purposes in mind,

Takaful, as Islamic Finance, can prove to become a significant proponent of daw’ah, i.e.

spreading Islam and thus opening inroads into the “insurance” needs of the larger population.

Figure 5

Adapted from Bank Negara Malaysia-2011 Statistical Report

Figure 5 depicts the growth trends in Family and General Takaful net contributions in

aggregate over the same 9 year period. Malaysia’s Family Takaful growth has been

impressive thus far. Net Family contributions have grown 385.7% from 2003 to 2011 or an

http://www.indexmundi.com/malaysia/demographics_profile.html

8

35

average 42.9% per year before adjustment for inflation. General Takaful grew 360.8% over

the same period; or an average 40.1% per year before adjustment for inflation. However,

growth has slowed. Family funds grew at an unadjusted 9.2% from 2010 to 2011; while

General funds grew at an unadjusted 12.4%.

The determinants for growth of Family and General Takaful are different. Though

there is the need for further research and testing in the area, recent studies have shown that in

addition to population growth, the following are some of the more significant determinants of

Family Takaful demand: income, employment rates, interest rates, financial development

(deepening as noted herein above), pensions, price, equity investment, education,

urbanization, age and household size. There appears to be a negative correlation with savings,

as it likely represents an alternate use of funds vis-à-vis Takaful; as well as inflation, which

tends to erode and contract demand for coverage (Yazid et al 2012). Some studies in the area

of conventional insurance draw correlation between life insurance and a nation’s GDP (Feyen

et al. 2011) and per capita income (Enz 2000). In any event, it would seem that properly

conducted empirical studies on Malaysian Takaful might lead to more precise insight into

growth prospects.

The determinants of growth for General Takaful are much different. They vary by the

area of risks or classification. For example, vehicle Takaful is directly correlated with the

number of vehicle drivers. Financial Takaful might be correlated with market activity, e.g. the

volume of sukuk issuances. Commercial based General Takaful might be correlated with the

number of firms in a nation (Michael-Kerjan et al 2009), their size, leverage, tax profile,

expected bankruptcy costs and managerial ownership (Hamid et al 2009). Or there may be

correlation with asset exposure risks. Shipping or trade related General Takaful might be

correlated with import and export activity. There is also evidence that suggests that non-life

insurance is correlated with cultural norms of power distancing, individualism and

uncertainty avoidance (Treerattanapun 2011).

Finally, BNM publishes annual statistic on new Takaful certificates and certificates in

force. For example, for calendar year 2011, there were approximately 940,800 new Family

Takaful certificates issued. This represents a fairly significant growth statistic given the size

of Malaysia. However, there were also 464,400 or so terminations during the same period.

This may indicate poor service, dissatisfaction, or plain ole hard economic times. There were

approximately 3,251,600 certificates in force at calendar year end; or again, roughly a ratio of

11% (roughly the same percentage shown in Figure 4, i.e. Takaful contributions to

conventional insurance premiums) when divided by the total Malaysia population. Economic

analyses of these numbers and possibly empirical studies may shed important light on the

issue of penetration in the domestic Family Takaful market. In order to develop the

innovative Takaful products needed to penetrate the General Takaful market and to benefit

from it growth, more industry and panel research may be needed.

As noted, Malaysia is a world leader in Takaful with approximately 20% of the

worldwide market. That is so even though Saudi Arabia is stated to garner about 67% of the

world’s “Takaful” market. However, Saudi Arabia has, since 2004, essentially required all

“Takaful” operators to use the cooperative insurance model. The cooperative model is not

pure Takaful and may not even be Takaful at all. It does not segregate participant funds, does

not require investment in Shari’ah-complaint instruments and is not required to have

36

Shari’ah advisory committees or boards. Moreover, Malaysia is positioned next to several

large potential markets mentioned in the E&Y report, i.e. Indonesia, Pakistan and India.

Other potential markets mentioned as possible targets are also within short reach of Malaysia,

i.e. China, Bangladesh and Turkey. And then there’s MENA, i.e. Middle East and North

Africa (E&Y op cit). All of these markets are within the “reach” of Malaysian Takaful.

Hence, the questions noted in the Abstract are particularly relevant. Will Malaysian Takaful

be able to compete in terms of performance, risk management and innovation? As it grows,

will it jettison its Shari’ah norms and prohibitions, as Saudi Arabia has apparently done; or

will Malaysia stay the course of being the world’s stalwart of Takaful and grow in a Shari’ah-

compliant and sustainable manner?

VII. Conclusion & Findings.

Our analytic review leads us to believe:

Malaysia is positioned well, both regionally and globally; but should expect stiff

competition from both the GCC and Indonesia

Malaysia’s strong global position is buttressed by its burgeoning Islamic Financial

system, robust regulatory oversight and involvement in development initiatives, and

the sheer force of will of the Malaysian people to establish the Shair’ah in their

financial lives.

General Takaful is set for a major boost over the forthcoming years, with the

emergence of new players to enhance the competitiveness of the industry and buoyed

by the continuing increase in public awareness of the Islamic financial products.

The rapid pace of development of retakaful business will reinforce and enable further

expansion of General Takaful business, particularly in the commercial lines.

The sound and conducive regulatory, supervisory and Shariah framework of Malaysia

that governs Takaful and Islamic Finance will continue to support sustainable growth

of Takaful; particularly General Takaful.

Need to build a critical mass of human capital needed to service the growth

anticipated in Takaful, including the need to monitor the Shari’ah risk associated with

only a few scholars and some sitting on numerous boards or committees

There is a need for greater harmonization of accounting practices & less opaqueness

in financial disclosures by Takaful operators.

Moving forward, product innovation will continue to be a key ingredient in attaining a

competitive growth.

The worldwide Muslim population is now estimated to be 1.6 billion. Family Takaful

has a positive correlation with population.

Takaful in Malaysia is only 11% of the overall risk intermediation market. There is a

significant opportunity for penetration that still exists domestically.

Takaful is a intermediate contract that can support other Islamic Finance transactional

contracts, e.g. in sukuk, REIT, etc. Thus, growth in worldwide Islamic Finance should

increase General Takaful’s base of business.

37

Innovative approaches to marketing, e.g. bancatakaful, as well as product

development (especially investment-linked and wealth management products) can

spur growth in contributions.

Offering tax incentives or tax favored treatment to Takaful contributions, investments

and income can trigger growth as it has elsewhere, e.g. the US (where insurance

products are given tax favored status). For example, limiting taxation of Takaful

surpluses to zakat might be considered or making contributions to certain classes of

Takaful, tax deductible, in whole or part.

Building smart partnerships and global alliances will allow Malaysian Takaful

operators to penetrate lucrative markets, e.g. the GCC and grow through cross-border

cooperation, e.g. in the new market potential of North Africa.

Marketing Takaful “generically” as ethical, socially responsible, even as a mutual

insurance scheme, can help penetrate Malaysia’s non-Muslim population and Western

countries.

Innovative Shari’ah based approaches to dealing with the problems already faced in

the West will be needed, e.g. rejecting applicants with “pre-existing” conditions

outside of the risk appetite of operators or “red-lining” risky areas or population

Takaful operators will have to be vigilant in guarding the epistemological foundation

that Takaful is built upon and not succumb to the temptations of placing too much

priority on profit, lest Takaful begin to mimic conventional insurance.

Takaful funds and operators should consider, and the regulator should assist,

expansion into new market segments through merger and acquisition possibilities,

where they exist.

Affordable Takaful plans, possibly subsidized by the government, should be

developed for the poor or other classes of the population; possibly linking them with

other micro-finance projects.

Takaful schemes might be linked with various pension and retirement schemes to

further penetrate the domestic and foreign markets.

38

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