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www.islamicnancenews.com TAKAFUL REPORT Analyzing Takaful and re-Takaful Companies: Concepts and Considerations (Part 1) By Standard & Poors Concepts of Takaful and our analysis Many concepts within Takaful can largely remain outside our analysis, most notably the idea that the customer is less a policyholder paying a premium to buy a policy guaranteeing protection and more an entrepreneur sharing risks with other participants on a mutual basis while paying a donation to participate in any surplus on the Takaful underwriting and investment funds after claims have been settled. Analytically, we remain unconcerned whether premiums need to be called Tabarru (donation, contribution, or gift), or whether policyholders are called participants. Similarly, we have no need to involve ourselves in any debate on compliance across the various schools of Shariah law, and it is not in our role as credit analysts to opine on the degree to which a given insurer or reinsurer avoids or falls foul of the ethical pitfalls of riba (usury), gharar (uncertainty), maysir (speculation or gambling) or involvement in activities deemed haram (prohibited by religion). Impact of Islamic principles on accounts Nevertheless, when the pursuit of Islamic commercial principles leads in our opinion to signicant changes in the way an insurer presents its accounts, then we aim to understand the details of what is happening. A brief glance at the report and accounts of almost any Takaful operation will reveal that both the balance sheet and income statement are split to reect the separate and sometimes divergent fortunes of the operating and shareholders accounts, with the surpluses on each being separately available to policyholding participants on the one hand and to shareholders on the other. A more detailed analysis of a variety of accounts prepared on a Takaful basis also reveals a number of signicant and sometimes complex features, particularly nancial cross-ows between participants and shareholders. Indeed, it soon becomes clear that the various forms of Takaful practiced can go well beyond the cooperative (taawuni) insurance model commonly found in Saudi Arabia, with possibly the most widespread in the Middle East now being the so-called hybrid WakalahMudarabah model. Under this model, the Takaful company as operator will levy Wakalah or agency fees against the various lines of business in the mutual operating fund, fees that are usually equal to some 15%-25% of gross written contributions (premiums). These Wakalah fees are intended to cover more or less exactly the routine operating costs of the company. Although technically a possibility, it is usually deemed unethical for a Takaful insurers board of directors to seek to generate a prot for shareholders by levying an articially high level of Wakalah fees. However, it occasionally happens that a company will subsidize its policyholder-participants by levying a deliberately low level of Wakalah fee, although an inadvertently low fee cannot be topped up in arrears by a supplementary fee if actual expenses during the year prove higher than anticipated. The second levy under the hybrid model is the Mudarabah (prot and loss sharing trust) fee, which is charged as a form of management fee © against either income or surplus on the Takaful investment fund, but not against the separate investment portfolio that relates to shareholders funds. By means of the Mudarabah fee and the investment return on the companys capital, Takaful company shareholders can expect to receive an acceptable return on their investment in a good year, while participant policyholders can expect to obtain not only Shariah compliant, mutualistic insurance protection, but also a potential share in any surplus on the Takaful operating account, a share which may be received as cash or, more commonly, in the form of a discount on renewal of the insurance cover. In the event of major losses, the possibility of a very large supplementary claim being made against policyholderparticipants could even arise What happens if the Takaful funds incur an overall decit? In our view, the crucial ambiguity that can arise with Takaful only becomes apparent when this question is posed: What happens if the Takaful funds incur an overall decit? The usual expectation is that the Takaful operator will debit the shareholders fund and extend an interest free loan, the Qard Hasan (benevolent loan), to the mutual operating account in order to reverse the shortfall, with this loan subsequently being repaid from future operating account prots. However, unless the Takaful operator has specically indicated in advance that it will provide a Qard Hasan from the shareholder account in the event of an operating account decit something upon which a competent Shariah board would normally insist then such a loan remains an implicitly discretionary undertaking under the terms of the Takaful agreement, as, technically, under a Takaful insurance contract it is the participant policyholders and not the shareholders who are mutually responsible to ensure that all claims are paid. This feature of a Takaful mode of operation therefore raises the possibility of a supplementary premium call being made against policyholders. This is occasionally seen with some French mutuals. In the event of major losses, the possibility of a very large supplementary claim being made against policyholder-participants could even arise, more akin to what may periodically occur in the international marine mutual (protection and indemnity) sector. We believe a result of this placing of the onus on policyholderparticipants rather than on shareholders to pay claims could be that Page 17 14th August 2009 www.islamicnancenews.com large supplementary calls are made against policyholders at exactly the same time as shareholders are withdrawing their still-intact equity from the company. Overcoming potential hurdles Our approach to these potential issues is to discuss them with the Takaful operations that we rate, with a view to ascertaining whether the Takaful managers have indeed mandated in advance to provide a Qard Hasan from the shareholders funds in the event of a decit on the operating account. TAKAFUL REPORT on the willingness and ability of its reinsurers to provide suitable protection? Similarly, will a legitimate desire to avoid noncompliant investments constrain a Takaful operators ability to prudently diversify its asset portfolio or, more signicantly, will Shariah compliance encourage overexposure to potentially volatile equity markets, or volatile and often illiquid property investments? The second and nal part of the article will appear next week. Moreover, we typically take a level of comfort from the fact that we would generally expect the Shariah board that exists within each Takaful company, and also the local insurance regulators, to exert pressure to ensure that a Qard Hasan is extended whenever needed. Concerns with the Takaful model If we do have questions regarding the Takaful model, these tend to center less on hypothetical issues and more on conventional analytical problems. For example, if the Wakala fee is levied as a percentage of the gross premiums or contributions written, is there not a danger of moral hazard? Will the Takaful operator be encouraged to maximize the income of shareholders by writing more business than may be prudent, and if too much risk is written, will the company then risk becoming dependent David Anthony Primary Credit Analyst, London Tel: +4420-7176-7010 [email protected] Lot Elbarhdadi Secondary Credit Analyst, Paris Tel: +331-4420-6730 lot[email protected] DID YOU KNOW THAT you could do a 3600 search on IFN ... www. Company prole UK: Faisal Alshowaikh told Islamic Finance news that h new head of Islamic nancial services for the bank, to b He will oversee the asset management unit alburaq, the business, trade and corporate nance as well as Islamic operations in Italy, France, Germany, Turkey and Spain Faisal’s responsibility. .com Know more about your K o r our ou clients in just one-click. 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The duration of the lease and the fee are set in in n and developed infrastructure to support future growth advance. During the period of the lease, the asset reiss very mains in the ownership of the lessor (the bank), but the lessee has the right to use it. After the expiry of the lease agreement, this right reverts back to the lessor. This is a classic Islamic nancial product. All key Islamic Finance Terminology in any article is explained when you put your mouse over the word. Click on the word and view all related articles © Page 18 Advanced Search Engine – for an exact hit on what you’re looking for Call us today + 603 2162 7800 14th August 2009