takafulmarketreview

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Copyright 2011 by A.M. Best Company, Inc.ALL RIGHTS RESERVED. No part of this report or document may be distributed

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BESTS SPECIALREPORTOur Insight, Your Advantage.

Takaful

Market Review

July 11, 2011

SectorTakaful

Additional Information

Special Reports:GCC: Rich in Potential, But Hurdles

Remain

Top Middle East Markets Are Poised forTakeoff

Southeast Asia May Reward Shrewd Insurers,Punish the Careless

Criteria:Takaful (Sharia Compliant) InsuranceCompanies

Analytical Contact:

Vasilis Katsipis, London,

+(44) 20 7397 [email protected]

Writer:

Yvette Essen, London

+44 20 7397 [email protected]

Takaful Poised for Growth, ButGreater Focus is RequiredTakaful operators in the Gulf Cooperation Council (GCC) andMalaysia are growing at a rapid pace and are enjoying strong capi-

talisation on a consolidated funds basis.

A.M. Best Co.s research compares the performance of takaful

operators to those of conventional insurers in the same markets.The findings indicate that:

Family business is more profitable than general takaful, and is

growing at a fast pace. Family takaful is also outpacing conven-tional life insurance, thereby representing the greatest opportu-

nity for profitable growth of takaful operators.

In general takaful, operators are growing quickly, but in mostcases this is a consequence of the rapid expansion of the insur-ance markets in these countries, as opposed to increased demand

for Sharia-compliant offerings.

Most general takaful operators tend to compete with conven-tional insurers on price because most start-up companies are fall-ing behind their original business plans. Takaful operators finan-

cial performance tends to be inferior to conventional insurers.

Most takaful companies are highly capitalised. This is partlythe result of many companies being in the early stages of opera-

tion and being capitalised at levels sufficient for when they wouldachieve operational maturity. In many cases, takaful funds havelow levels of excess resources as these are retained at the opera-

tor/shareholder level.

There are positive regulatory developments occurring in sev-eral markets, with the introduction of specific takaful regulation.

However, in most countries there is considerable uncertainty asto the priority of liabilities in the case of insolvency of a takafulcompany. This could prove critical given the typically low levels

of capitalisation of takaful funds.

A.M. Best believes takaful will continue to be among the fastest

growing segments of the GCC and Malaysian insurance markets.The ability of takaful operators to increase insurance penetrationis critical to their success. Family takaful currently presents thegreatest opportunity to achieve this because it provides the Mus-

lim population with alternative protection and investment oppor-tunities, and the takaful insurers with increased profitability.

To ensure its longer term viability, the sector needs to improve

its ability to retain earnings within the takaful fund and focus onproduct differentiation as opposed to competing on price.

BestWeek subscribers have full access to

all statistical studies and special reports

at www.ambest.com/research. Some

special reports are offered to the general

public at no cost.


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Special Report July 11, 2011

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To an extent, general takaful has beenbuoyed by increased demand for protec-

tion in growing economies where com-pulsory lines of insurance have beenintroduced. In most cases, markets where

takaful is offered are enjoying growthin gross domestic product (GDP) and

increased consumer wealth which, in turn,has resulted in significant increases in

insurance premiums for the market as awhole.

As a result, most takaful companies arecompeting with conventional insurers on

pricing for the same business, rather thanthrough a differentiated value proposition

based on the ethical values of takaful.

Competition within personal lines prob-ably will continue as the recent economic

turmoil has resulted in the postponementof capital-intensive projects. Customersare likely to continue to purchase the most

cost-effective product, as opposed to pay-ing extra for an offering that is Sharia com-

pliant.

Takaful contribution volumes have

increased sharply over the past few years;however, most takaful companies that have

started trading in the past five years havefallen behind their original business plans.

Companies with overly optimistic growthtargets have revised their projectionsdownward as an influx of new takaful com-

panies coincided with the downturn in eco-nomic conditions. Some are still struggling

to meet these new business plans.

Retakaful: Great Potential FailsTo MaterialiseIn general, retakaful has also failed to grow

as rapidly as initially expected. While therehas been tremendous growth in the prima-

ry takaful market over the past few years,

this has not translated into commensurateincreased retakaful demand because taka-ful operators have been utilising traditionalreinsurance capacity.

The majority of retakaful companies are con-

sequently engaged in traditional reinsurancebusiness. The growth of the retakaful market

depends on whether primary takaful opera-tors come under pressure to alter their rein-surance purchasing patterns and seek Sharia-

complaint cover for themselves.

Family Takaful RepresentsBest OpportunityIn general, life assurance is viewed as anopportunity for both conventional insurersand takaful operators. Family takaful busi-

ness is more profitable than general takafulbusiness, offering higher margins and sta-

bility, and is growing at a faster pace. Thisis a new market that is not served particu-

larly well by conventional insurers.

Exhibit 2 shows that family takaful premi-um of the sample companies grew by a 22%CAGR from 2004 to 2009 to USD 456 mil-

lion, in particular driven by GCC premiumdevelopment. Although this was from a low

initial base, it was at a considerably fasterrate than the conventional life market,

which grew by 5% over this period.

Family/Life Premium DevelopmentFamily takaful premiums have grown par-ticularly strongly in the GCC at an 86%

CAGR over 2004 to 2009. The Malaysianmarket has a more developed takaful

market and has experienced more stablegrowth in the past few years but again,takaful companies have outperformed tra-

ditional Malaysian life insurers.

Family takaful has also increased its pres-ence over this six-year period. In 2004, the

companies followed by A.M. Best in thesemarkets represented 5% of the total familytakaful and life market. In 2009, this figure

had more than doubled to 10.2%.

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Exhibit 2

Takaful vs Conventional Family/Life GWP*Development (2002-2009)

0

1,000

2,000

3,000

4,000

5,000

TakafulConventional

20092008200720062005200420032002

USDMillion

s

*Gross Written Premium

Source: A.M. Best Co., BestLink

AMB


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Family Takaful DeliversHigh Levels of ProfitabilityFamily takaful has tended to be more prof-itable than conventional life insurance (see

Exhibit 3). From 2002 to 2009, conventionallife insurers have delivered a return on lifepremiums of 7.2% to 9.4%. Profitability of

family takaful business tends to be morevolatile owing to more aggressive and con-

centrated investment portfolios.

As a result, traditional life insurers outper-formed their takaful competitors only dur-ing 2009 when return on life premiums was

7.3% for takaful operators, compared to9.4% for their counterparts.

This was not a consequence of takaful

operators risk selection, rather a resultof their asset composition with their

investments being concentrated in sukuks(Sharia compliant bonds) and private

equity investments, which were among thehardest hit by the global downturn. A.M.Best expects that in 2011, the financial per-

formance of family takaful operators willbe higher than that of the conventional life

insurers.

Higher profitability has been accompaniedby upstreaming of profits to the operators

funds, with takaful operators consistentlyoutperforming their conventional counter-parts. This, if continued, will enhance the

appeal of takaful business and its accep-tance among the insured public.

Financial Performance of GeneralTakaful Improves but VariedThe financial performance of takaful com-

panies has improved, although this variessignificantly between operators. Familytakaful is very profitable while the profit-

ability of general takaful depends on indi-vidual market and operator expertise.

In Malaysia, more stable growth hasenabled takaful companies to post greater

profits than takaful operators in the GCC.Malaysian takaful operators have also con-

sistently outperformed their traditionalcompetitors (see Exhibit 4), with com-bined ratios for takaful operators rangingfrom 93% to 74% in recent years.

Profitability of General InsuranceIn the GCCHowever, it has been a different picturefor the GCC market where general takaful

profitability has suffered from intense com-petition. The GCC has a younger takafulmarket, with most of the takaful companies

being in the early years of their operations.The influx of new capital for the establish-

ment of new takaful operators combined

with the economic slowdown of recentyears has meant that takaful operatorsneed to compete on price in order to buildup a presence and achieve the volumes

anticipated in their original business plans.

While combined ratios have been below100% since 2003, the financial performance

of takaful operators is below those ofconventional insurers in the GCC. In 2009,combined ratios were 87% for takaful

0%

3

6

9

12

15%

TakafulConventional

20092008200720062005200420032002

Exhibit 3

Takaful vs Conventional

Return on Family/Life Premiums (2002-2009)


AMB

Exhibit 4

Takaful vs Conventional Malaysia

General Insurance Combined Ratio (2002-2009)

70%

75

80

85

90

95

100

105

110%

TakafulConventional

20092008200720062005200420032002


AMB


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companies, compared to 83% for conven-tional insurers (see Exhibit 5). It has beenincreasingly difficult to attract profitablebusiness against the more established con-ventional insurers, which also benefit from

high levels of reinsurance commissionsreceived for the high risk business that

they normally front.

As a result, general takaful businesshas been experiencing approximately

10 percentage points higher acquisitionexpense ratios. This, combined with thehigher management expenses especially

among start-ups, has resulted in operatingexpense ratios of 25% in 2009, compared to

19% for traditional insurers. This expensegap has been higher in prior years and has

previously reached 15 percentage pointshigher than their traditional competitors.

Underwriting performance as measuredby the claims ratio has remained remarkably

close for conventional and takaful companieswith a few companies in both sub-segments

consistently deviating from the norm.

The difficulties that newer takaful entrants

face in delivering technical profits pose aquestion as to their long-term viability. The

willingness of their shareholders to contin-ue to support these companies indefinitely

will be tested if returns continue to lagbehind original expectations.

Technical profitability will remain the mostimportant driver for the viability and the

rating of many takaful companies. However,with technical profitability lagging behind

that of conventional insurers, investmentperformance becomes critical for the com-petitiveness of takaful operators.

Investment Performance GoodBut Volatile

In terms of asset allocation, most GCC andMalaysian takaful operators appear tofollow the pattern of their domestic mar-kets, having very similar proportions of

asset classes as conventional insurers butwith emphasis on sukuk investments as

opposed to conventional fixed income anda higher exposure to private equity.

A.M. Bests analysis shows 57% of assetsheld by takaful operators were in higher

risk investments such as shares (whichinclude private equity), loans and real

estate (see Exhibit 6). This is comparableto the asset mix of conventional insurerswhich have a similar investment in high-

risk categories (61%); however, the con-ventional companies investment in private

equity is markedly lower, representing 27%of their share portfolio, compared to 36%

for takaful companies.

Investment Asset MixOf Takaful CompaniesTakaful market participants additionally

face more restricted investment policiescompared with their conventional counter-

parts. The supply of sukuk products in themarket is limited in comparison with con-

ventional bond offerings.

Therefore operators have a higher concen-tration of assets in their investment portfo-

Exhibit 5

Takaful vs Conventional

GCC* General Insurance Combined Ratio (2002-2009)

75%

80

85

90

95

100

105%

TakafulConventional

20092008200720062005200420032002

*Gulf Cooperation Council


AMB

Exhibit 6

Takaful Investment Asset Mix (2002-2009)


AMB

0%

10

20

30

40

50

60

70

80

90

100%

2002 2003 2004 2005 2006 2007 2008 2009

Cash Sukuk Shares Real Estate Other Affiliates Loans

57%


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lios. From 2004 to 2009, takaful companieshave suffered greater capital losses, both

realised and unrealised, in comparison totheir conventional counterparts.

Since 2006, conventional insurers in theGCC and Malaysia have delivered a better

return on their investments (see Exhibit7). In 2009, takaful companies had aninvestment yield of 3%, compared to a 5%return for conventional insurers in the

sample.

Excellent Capitalisation of TakafulOperatorsBoth takaful operators and conventional

insurers in A.M. Bests sample enjoy strongrisk-adjusted capitalisations. In many

cases, takaful companies have better capi-tal adequacy than conventional insurers

and local operations of international com-petitors. In part, this is a consequence ofthe early phase of their operating life and

the fact that several start-up companies arefailing to fulfil their initial business plans.

At the same time, capitalisation of takafulfunds is kept low in most cases, especially

among new operators. Most new compa-nies that are generating any underwriting

profits are delivering these to the opera-tors fund, resulting in a minimal retention

in the takaful fund.

While this practice is viable in the short

term, it creates uncertainty about thelong-term prosperity of takaful funds. The

building up of sufficient capital resourceswithin the takaful fund is imperative for a

secure A.M. Best rating, and the retentionof earnings, especially in the early years of

operation, is the only way for takaful fundsto achieve their long-term viability.

In many cases there is a continuous depen-dence on the qard hassan (benevolent loan

from the operator to the takaful fund).This can only be a short-term solution

and at the same time, it brings to the forethe uncertainty surrounding the priority

of policyholder liabilities in many takafulmarkets. In many cases there is no clarityas to the priority of policyholder liabili-

ties, and often there is neither provisionnor jurisprudence that would indicate the

prevailing legal system (temporal versusSharia law) in case of the default of a taka-

ful company.

Country Risk ImprovesIn Takaful MarketsA.M. Best expects the operating environ-

ment to improve for most of the countriescovered in this report, with the main driver

being the rebound of most economies.

As part of A.M. Bests country risk rating

methodology, countries are placed into oneof five tiers, ranging from CRT-1 (Country

Risk Tier 1), denoting a stable environmentwith the least proportion of risk, to CRT-5

(Country Risk Tier 5) for countries posingthe greatest risk. All GCC countries andMalaysia have an A.M. Best CRT-3, which

is at the top end of the scale for emergingcountries.

A.M. Best considers there to be positive

developments in several markets becauseof the introduction of takaful specific regu-lation and minimum capital requirements,

including in the UAE, Saudi Arabia, Bahrainand Malaysia.

As A.M. Bests primary focus is the assess-ment of financial strength and policyhold-ers security, the rationale and financialincentives on which the allocation of prof-

its between policyholders and sharehold-ers is based is of particular interest.

In many markets the seniority of policy-

holder claims remains unclear. Regulationhas yet to be tested regarding the ring-fenc-ing of assets within the takaful fund and

0%

1

2

3

4

5

6

7

8

9%

Conventional Takaful

200920082007200620052004

Exhibit 7

Takaful vs Conventional Investment Yield (2004-2009)


AMB


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the use of a qard hassan from operators,should the fund become insolvent.

An upstreaming of profits to the operatorsfund by the younger takaful companies

has resulted in several policyholder fundsbeing significantly undercapitalised. Con-

sidering the continuing competitive natureof the market, in A.M. Bests opinion, this

seems a precarious position.

The Islamic Financial Services Boards(IFSB) publication of the Standard on Sol-vency Requirements for Takaful (Islamic

Insurance) Undertakings in December2010 is welcome. The key principles and

standards set by the IFSB, if adopted bylocal regulators and takaful operators, will

provide additional security and uniformity.It is still unclear for many countries as to

whether Sharia or temporal law will takeprecedence in the event of a takaful opera-

tor becoming insolvent.

Many markets where takaful companies

operate are considering implementingInternational Financial Reporting Stan-

dards. A uniform accounting standardis particularly welcome, as this would

improve consistency and transparencyamong companies.

Takaful financial transparency hasimproved significantly over the past two

years. However, there are still operatorsthat fail to specify the financial perfor-

mance of their funds. Furthermore, thereis inconsistency as to how different

funds are consolidated on the operatorsbalance sheet.


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