Double-digit growth in Takaful will continue but underlines the need to identify value propositions and resolve operational issues
Despite ongoing, rapid growth in Shari'ah-compliant insurance markets, Standard & Poor's Ratings Services says that operational issues remain commonplace in the sector. In fact, this issue was the focus of some heated discussion at the International Takaful Summit in London in July (Islamic Business & Finance was 'Official Content Partner' to the Summit).
Standard & Poor's believes that while the essential Shari'ah-compliant operational model affords a further level of corporate governance, particularly so in those domiciles where corporate governance is poorly established, often the Shari'ah interpretation creates a more complex, and so potentially inefficient, operational model compared with conventional insurance companies. And since conventional companies employ tried and tested systems, are typically long established, and have larger business volumes, they deliver better economies of scale that some Takaful companies are struggling to achieve.
On the plus side, many Takaful operators sensibly hold the opinion that Shari'ah restrictions act as a unique selling feature and, as such, are not an impediment to product innovation. Further, despite the acknowledged shortage of suitable assets, a factor which does tend to limit product design, most operators remain comfortable with the concentration risk of assets by class, geography and ownership.
December 2010, the Islamic Financial Standards Board (IFSB) published IFSB 11 Standard on Solvency Requirements for Takaful (Islamic Insurance) Undertakings. Separately, Auditing & Accounting Organisation for Islamic Financial Institutions' (AAOIFI) standards also cover the application and interpretation of Shari'ah law for the Takaful sector.
MATTER OF INTERPRETATION
It should go without saying that within the Takaful industry the scholarly interpretation of religious texts is essential. However, inevitably, such interpretation can differ widely. Standard & Poor's says the variety of interpretations of Shari'ah law within the Takaful sector, and its auditors, is causing material inconsistency in the published accounting information from the sector.
IFSB 11 requires the separate solvency monitoring of Takaful funds from shareholder (operator) funds. As Takaful funds are the sole responsibility of the members (contributors), Standard & Poor's' analysts say they see some regulatory logic in this but qualify their approbation by suggesting that it seems to ignore the role of the shareholder in its active support and management of the Takaful fund, as demonstrated through the provision of Qard Hassan (interest free loans), solvency margin and capital employed.
In its interactive ratings of Takaful companies, Standard & Poor's is of the opinion that there is real fungibility from shareholder funds (and the attaching assets) to the Takaful fund if the latter is in deficit (unless demonstrated otherwise). At the early stages of a company's development, when Takaful fund deficits could be likely, this standard could create an onerous set of operational constraints.
SURPLUS TO REQUIREMENTS
AAOIFI proposes that Takaful fund surpluses can only be distributed to the managers of the Takaful fund and therefore not to members, as is commonly understood to date, nor the investors in the company. Concerns were raised at the Summit that such a ruling may create real moral hazard for both the fund members and the shareholders. As an example, for certain types of underwriting risk, claims development can happen over many years, and it is conceivable that a fund that is apparently in surplus for years one to four can turn into deficit in year five. Questions that arise from this ruling are: if those surpluses are distributed prematurely to the management team, are they subsequently recoverable from that team? Or is it the responsibility of the current/new members to restore the health of the Takaful fund?
To date, the core business of the Takaful sector has tended toward high volume/low value types of risk with short-tail claims development characteristics, typically the retail sector such as motor and medical. Where the risk profile of the Takaful fund is homogenous, then the establishment of and distribution of surpluses to members should be uncontroversial.
However, as the Takaful sector grows in scale, it will increasingly seek to underwrite larger risk values in more commercial sectors, for example, marine and aviation. Although use of ReTakaful capacity can control loss exposures from high-value covers, there is a question regarding the feasibility of a single Takaful fund comprising such a heterogeneous mix of risks. For example, a large commercial loss event on an aviation risk could push a fund into deficit, when the retail contributors from very different risk-types, such as motor and medical, remain in surplus. Therefore, should they realistically be expected, under the cooperative doctrine, to support risks, which as individuals they are totally unfamiliar with? This aspect of Takaful fund management is less of an issue for the ReTakaful sector.
Similar issues face the family Takaful sector. The underlying drivers for family Takaful and general Takaful are markedly different and a viewpoint that combines them may tend to lead to distorted results. With bottom line profitability for general Takaful facing stiff competition from a relatively soft market, family Takaful may be seen as the more sustainable proposition with a strong bottom line outlook. To date, the core business has been very short-tail medical risks, but as the longer-term life risks develop, the members of such different operational risk types could be combined.
The London Summit also saw the launch of the 1st Global Family Takaful Report by Milliman, one of the largest consulting and actuarial firms in the world. The report provides analysis of industry growth for family Takaful by key regions and takes an in-depth look at the financial highlights for Malaysia where the market is well-established and regulated. It sets out a detailed regulatory update for each of the key regions, along with a summary of the key models used and key products markets in those regions.
The potential opportunity that exists within family Takaful may be easily identified by one statistic - life insurance premiums in Muslim countries as a percentage of world premiums stood at just 0.72 per cent in 2009.
Milliman estimates global family Takaful gross contributions in 2010 at $1.7 billion, up 24 per cent on 2009 and further points out that gross contributions increased at a compound annual growth rate of 36 per cent over 2007-2010. By 2015, Milliman forecasts gross contributions to reach $4.3 billion. In geographical terms, Southeast Asia will remain the market leader but within the region, Indonesia, which is growing at a faster pace than Malaysia, will reach parity in terms of market share with the more developed market in its neighbour.
Among the key findings of Milliman's report, the firm noted that most family Takaful players have distributed surplus, although only a handful have distributed 100 per cent of surplus arising or none at all. Only a small proportion of operators shares in underwriting surpluses (incentive fees). Surplus distribution, or its potential, is broadly viewed as a major attraction for Takaful product and crucial for the future sustainability of the industry.
One may reasonably expect a Takaful company to have at least good risk-based capital adequacy, which encompasses prudent technical reserving, the issues highlighted here are very much internal management issues for each company. However, they are an indication of the still-evolving operational framework for the sector that creates ongoing uncertainty.
Standard & Poor's believes the successful development of the Takaful sector depends on the identification and promotion of a real value proposition that is distinctive from that being offered in the conventional insurance sector. Focusing specifically on family Takaful, Milliman said, "For family Takaful to survive to the next generation and beyond, concerted effort is required by practitioners, operates, Shari'ah scholars and regulators to synchronise their efforts. This will ensure a convergence of ideas whilst at the same time respecting the plurality of thought and practicality of the proposition.