Legal and Regulatory Issues in Takaful

By: Camille Silla Paldi

Takaful

Takaful is almost the same concept as conventional mutual insurance, except that the takaful operator can inject an interest free loan called qard hassan into the fund in the event of insolvency.

Islamic insurance is based on cooperative risk sharing and joint-guarantee, which are concepts already widely used in the West and favored by ethical people, Christians, Muslims, and Jews.

Takaful can be considered a form of investment insurance with coverage and is a valuable financial tool for people seeking coverage, investment returns, diversification of portfolios, wealth management, and retirement plans.

It is also quite useful and widely used by people of all faiths, nationalities, and backgrounds in international trade finance.

Takaful Dispute Resolution

Takaful disputes are largely settled in civil and common law courts, similar to Islamic finance transactions.

This may be problematic due to the non-application and misapplication of Shari’ah and the lack of understanding of Islamic finance and Islamic insurance in civil and common law courts.

Malaysia

Parallel Shari’ah and Civil Court System.

Since Bank Islam Malaysia Berhad v Adnan bin Omar and Dato Nik Mahmud bin Daud v Bank Islam Malaysia Berhad, banking matters fall under mercantile laws, which according to the Federal Constitution, shall be under the Civil Court’s Jurisdiction.

If an Islamic finance of Shari’ah issue arises, the civil court can then refer the matter to the National Shari’ah Advisory Council at Bank Negara Malaysia for a ruling.

Countries with Specific Takaful Legislation

Malaysia

Brunei

Pakistan

If only three countries possess Takaful legislation, the global Takaful industry is heavily under-regulated as well as lacks as proper dispute resolution mechanism.

Bank Negara Malaysia Guidelines

Guidelines on Operating Costs of Family Takaful Business;

Guidelines on Claims Settlement Practices;

Guidelines on Directorship for Takaful Operators;

Guidelines on Prohibitions against Unfair Practices in Takaful Business;

Takaful (Prescribed Financial Institution) Loan and Investments Regulation 2003;

Guidelines on Financial Statement for Takaful Operators;

Takaful Operators Statistical System.

Takaful

A unique and harmonized regulatory and reporting regime is required for takaful for many reasons including the two-tier structure of takaful companies, which includes shareholder and policyholder funds.

Shareholder and policyholder funds are managed separately and capital may not be fungible or transferable between the two separate accounts.

Furthermore, takaful funds have unique policyholder entitlements and rights, different structures, and face different risks compared to conventional insurance.

Takaful

The main difference between conventional and Islamic insurers lies in the fact that in Islamic finance, the assets underlying the underwriting pools are owned by the policyholders, whereas assets in conventional proprietary insurance companies are owned by the shareholders and must at all times be sufficient to cover their obligations to the policyholders.

Accordingly, in contrast to conventional insurance companies, takaful companies must make disclosures about the underwriting pools and underlying assets.

Takaful

The AAOIFI regulations FAS 12 General Presentation and Disclosure in the Financial Statements of Islamic Insurance Companies and FAS 13 Disclosure of Bases for Determining and Allocating Surplus or Deficit in Islamic Insurance Companies address many of these issues.

The AAOIFI standards require disclosures on policyholders’ funds and the determination and allocation of surplus and financing of deficits.

However, the requirements in respect of movements between the funds should be enhanced and the individual rights of the policyholders should be clearly stated in the financial statements.

Takaful

There is also a lack of transparency in the financial statements of some takaful companies in regards to undistributed fund balances.

Overall, the current financial reporting practices of takaful companies do not provide adequate information regarding the company’s investment strategy, funds allocation, and revenues and expenses accruing to their particular investment funds.

Exacerbating the situation, takaful companies have not yet adopted a single framework for financial reporting and this has resulted in the lack of transparency and comparability of financial statements.

Takaful

In terms of capital adequacy regulation, it may be difficult to apply ratio-based methods as it can be difficult to accommodate them to the different structures adopted by takaful operations and their different risk profiles.

For this and other reasons, it is more advantageous to develop risk-based capital regulation (RBC) for the takaful industry.

In the RBC, calculating the capital requirement is combined with evaluating management practices and internal controls. In this process, there is a major role for the regulator in reviewing and evaluating the process by which the calculated capital requirement was arrived at and imposing additional capital add-ons if the regulator is not satisfied with the insurer’s risk management.

Takaful

In this process, there is a major role for the regulator in reviewing and evaluating the process by which the calculated capital requirement was arrived at and imposing additional capital add-ons if the regulator is not satisfied with the insurer’s risk management.

The insurer determines its minimum capital requirements by applying risk factors to each of the identified risk components, reducing the resultant amounts by identified risk mitigants, and aggregating the results.

Some further reductions may be possible by identifying diversification effects, though on the other hand the regulator may impose add-ons.

Takaful

Takaful operators may be comparatively overweight in assets such as equities and real estate, which tend to be more volatile and/or less liquid, thereby attracting higher risk weightings.

In many jurisdictions, solvency and capital requirements for takaful companies remain simple, however, several countries including Malaysia, Indonesia, and certain GCC countries are moving towards risk-based capital regulation.

Takaful

Takaful is faced with various other challenges including scarcity of suitable Shariáh compliant investments and very few retakaful or reinsurance operators in the world today.

These shortages can lead to concentration risks or lower-quality assets than desired by the takaful business.

Furthermore, there is a limited availability of risk management tools for takaful similar to Islamic finance and more attention needs to be paid to product design, IT, and control processes.

Takaful

Takaful investment management requires further development in Islamic financial theory and practice.

Develop Shari’ah compliant risk management techniques.

Shari’ah Boards

Takaful operators generally have their own Shari’ah Boards to ensure compliance with Shari’ah.

Very few jurisdictions have a central Shari’ah Board.

This may benefit the industry by ensuing a unified opinion throughout the jurisdiction on Shari’ah issues relevant to the industry and to provide a solid legal backing to a fatwa so that Shari’ah compliance will be effective and enforceable in the courts.

Shari’ah Boards

The lack of legal backing for the establishment of Shari’ah Boards, as well as adequate regulatory rules may continue to raise doubts regarding the effectiveness and enforceability of the contracts employed by takaful operators.

Investment Activities of Takaful Operators

Takaful operators are both insurers and fund managers and the Takaful regulations and legislation should reflect this.

This also requires the appropriate legal, financial, and administrative firewalls.

Takaful operators require a unique governance structure that facilitates (i) the consistent screening of the investment portfolios in order to ensure they remain Shari’ah compliant; and (ii) the purification of any return on the investment from non-Shari’ah compliant income. (Takaful legislation exists only in Pakistan, Brunei, and Malaysia) This governance structure requires legislation as a basis for the corporate structure and regulation.

Investment Activities of Takaful Operators

The financial regulatory authority might be interested to know how the takaful operators dispose of their non-Shari’ah-compliant income, particularly vis-à-vis related-party transactions that may involve conflicts of interest.

It may be useful to supervise the investment activities of the takaful operators borrowing some of the principles used by securities regulators.

Takaful Management Models

The contract between the participants and the licensed Takaful operator could be based on Wakalah or Mudarabah or a hybrid of the two. 

This contract refers to a management contract between the participants and the Takaful operator.

Takaful Management Models

Mudharabah

Wakalah

Hybrid Wakalah-Waqf Model

Waqf

Instead of using the principles of mudarabah or wakalah, takaful schemes should adopt the principle of waqf, which would make it clearer that a takaful undertaking is strictly non-commercial and based on the principle of mutual assistance.

In common law countries such as the UK, Paksitan, and Malaysia, a waqf would likely be governed under the Trust Law of the country.

However, a key question is whether in a waqf-based takaful model, whether the parties can contract out of the statute by creating sets of roles and responsibilities for the trustee under the waqf deed, which are different from those already specified in the Trust Act.

Waqf

A takaful operator may also need to register each takaful fund as a waqf in order to enjoy tax benefits normally granted to a waqf as a charitable entity; otherwise, a different tax treatment may be applied to those waqf.

Qard Facility

The takaful operator grants a qard or interest free loan in the event of a deficit in the takaful fund (in contrast to mutual insurance).

The takaful operator is expected to offer a qard loan facility, which can be drawn down if the fund is unable to meet its obligations (because of a deficit or lack of liquidity).

The loan does not remove a deficit, as it increases the fund’s liabilities simultaneously with the assets, but it provides liquidity to enable the fund’s obligations to be met.

Qard Facility

The loan should be recoverable by the takaful operator through future underwriting surpluses.

Considering that the takaful fund is under the direct management of the takaful operator, such a loan may fall under the broader context of ‘related party.’

Related party transactions must be publicly disclosed and only carried out on an arm’s-length basis without any unduly favorable terms.

In some jurisdictions, independent valuations and appraisals are required before the regulatory authorities will allow substantial related-party transactions to take place.

Qard Facility

This is in order to avoid the directors and management of the company manipulating the movement of funds or assets of the company in favor of certain parties who are related to or favored by them.

Qard Facility

Should the requirement to publicly disclose the qard facility be similarly imposed on takaful operators on the basis that it is a related-party transaction?

Should the existence of the facility be disclosed or only the loan if the facility is actually drawn down?

While it would seem desirable to disclose the existence and amount of the facility, transparency would also require disclosure of the draw-down amount when made.

Certain safeguards may also be required in order to ensure that the qard is not employed in a manner that favors certain pools among the many pools of takaful funds under the management of a takaful operator.

Qard Facility

In countries such as Malaysia, takaful operators are obliged to give an undertaking to the regulator to provide a qard facility to be drawn down in the event of a deficit of a takaful fund.

Contractual Clauses

Takaful, like conventional insurance, is based on the principles of insurable interest, indemnity, subrogation, and utmost good faith.

Insurable interest ensures that a client can obtain insurance only if susceptible to loss for which insurance is sought.

Indemnity implies that a claim can be made only to the extent of the actual financial loss to be insured.

Subrogation entitles insurers to claim from a third party on behalf of the insured.

Indemnity and subrogation together ensure compliance with the requirements of insurable interest.

Contractual Clauses

The utmost good faith clause is required for the disclosure of all material facts.

Takaful participants should be protected by the financial regulatory authority and contractual clauses should be standardized.

In addition, some takaful participants may make dishonest claims and thus, adequate legal protection should be given to the other participants.

Takaful Operator as Agent

Disputes and ambiguities may result from the almost absolute discretion of the takaful operator to act as agent for the takaful participants in the management of the takaful fund investments and the utilization or distribution of underwriting surplus and any misconduct or negligence on the part of the takaful operators.

Takaful Operator as Agent

Often, takaful operators hire other agents to market takaful products and to deal with the participants on behalf of the operator.

These additional layers of principals and agents add complications, particularly in relation to the fiduciary duties of takaful operators, the conduct of the agents/brokers, and how takaful participants seek remedies for any loss attributable to misconduct and negligence of the takaful operators.

Effect of Nomination Clause on Islamic Succession Laws

A nomination clause in an insurance policy may allow a Muslim to violate the rules of wills and inheritance as a person nominated may be an heir and/or may end up getting more than one-third of the assured’s estate.

This is so because a nomination is made by the assured during his lifetime but takes effect on his death.

On the other hand, some scholars argue that a takaful benefit should not be considered as part of the deceased’s estate, because it does not form part of the deceased’s assets during his lifetime.

In fact, the takaful benefit comes from a pool of funds derived from donations of other takaful participants as well, in part even after the deceased has died.

Effect of Nomination Clause on Islamic Succession Laws

In Pakistan, in the case of Karim v Hanifa, it was held by the Karachi High Court that the status of the nominee in life insurance is nothing more than an agent (or executor) who receive the benefit on behalf of all the heirs.

In Malaysia, the NSAC resolved in 2003 that whether a nomination clause in a takaful contract results in the takaful benefit being a hibah (gift) or part of the deceased’s estate, which is subject to inheritance, depends on how the clause is constructed.

Proprietorship

Most takaful operators are licensed as proprietorships and not mutuals.

However, in reality, they are mutual operating within the set-up of a proprietorship body corporate.

Here, what is supposedly a mutual, that is, the takaful participants coming together to make contributions (replacing the premiums in conventional insurance) and thus, rightfully owning whatever is in the takaful fund, including any assets and liabilities – is actually operated and managed, almost with absolute discretion, by a proprietorship corporation – that is, a takaful operator – acting as the managing agent on behalf of the takaful participants.

Proprietorship

It cannot be treated as a mutual when the law of the country does not accommodate the setting up of such forms of company with no shareholders.

Moreover, the regulators issue the takaful license specifically to the takaful operator on the basis of its form as a proprietorship with properly identified share capital and shareholders.

Thus, as far as the regulators are concerned, the takaful scheme is not a mutual.

It is not purely a proprietorship either, as we cannot erase the actual ownership of the takaful fund in which the takaful participants pool their money – these funds are certainly not the shareholders.

Proprietorship

In other words, to treat the takaful scheme as a pure proprietorship would jeapordize the whole takaful concept and contracts.

THE END