THE TREATMENT OF QARD IN TAKAFUL

By: Camille PaldiCEO of FAAIF The Takaful Rendevous, Mandarin Oriental HotelAsia Insurance Review; Middle East Insurance Review Kuala Lumpur, Malaysia, September 29-30, 2015

CONVENTIONAL V ISLAMIC INSURANCE A conventional insurance company speculates on the risk by making an assessment of the risk and then pre-determining profit based on the estimated payout versus the premium. 

It is in a sense gambling (Paldi: 2014).

Proprietary insurance is concerned with risk transfer, insured risks being transferred from the insured to the insurer in return for a premium;

CONVENTIONAL V ISLAMIC INSURANCE Takaful is concerned with risk-pooling, whereby the policyholders (takaful participants) mutually insure one another in a common risk pool financed by their contributions (premium payments).

Takaful, or Islamic insurance, is a cooperative scheme, where in which the participants pay a premium in the form of donation or tabarru in a common pool in return for the ability to draw upon that pool upon a valid claim.

The word takaful originates from the Arabic world kafalah, which means "guaranteeing each other" or "joint-guarantee."

CONVENTIONAL V ISLAMIC INSURANCE The basis of shared responsibility is taken from the system of aaqilah, which was an arrangement of mutual help or indemnification customary in many tribes of the Arab world.

Under this system, if a member of a tribe was accidentally or unjustly killed, the murderer was obliged to pay blood money (dia) to the deceased's next of kin as a form of life insurance for the deceased's relatives.

CONVENTIONAL V ISLAMIC INSURANCE In conventional insurance, riba (interest) occurs as the amount of money received by the insured, either on the occurrence of the insured event or upon maturity of the policy may be more or less than what is actually paid by the insured. 

Furthermore, since the payments are deferred, the compensation paid, which is greater than the instalments paid by the insured may constitute surplus riba (riba al fadl) and credit riba (riba al-nasiah). 

Secondly, the profits of conventional insurance companies result from riba related transactions (ISRA: 2012).

CONVENTIONAL V ISLAMIC INSURANCE In addition, conventional insurance contracts contain gharar (uncertainty) in that the subject-matter of the contract is not certain until the insured event has taken place. 

The amount being paid by the two parties is not known at the time of execution of the contract. 

CONVENTIONAL V ISLAMIC INSURANCE For example, an accident may occur immediately after the insured makes the first payment requiring a payout or he or she may make all the payments without any accidents happening, never receiving any compensation back from the insurance company during the duration of the policy (ISRA: 2012).

CONVENTIONAL V ISLAMIC INSURANCE In a conventional insurance contract, the policyholder agrees to pay a certain premium sum in consideration for the guarantee of the insurance company that they will pay a certain sum of compensation in the event of a valid claim.

However, the policyholder is not informed of how much compensation the company will pay him or her or how the amount shall be derived (ISRA: 2012).

CONVENTIONAL V ISLAMIC INSURANCE Maisir or gambling means to court such risk as it involves both the hope of gain as well as the fear of loss, which is not a necessary part of any normal activity in life. 

In conventional insurance, policyholders are gambling by betting premiums on the condition that the insurer will make payment contingent upon the circumstance of a specified event. 

On the other hand, the insured does not get anything from his premiums if the insured event does not happen at all (ISRA: 2012).

TAKAFUL MINIMIZES RIBA AND GHARARTakaful minimizes riba (interest), gharar (uncertainty), and maisir (gambling) through its cooperative donation scheme (tabarru) and investment in halal activities.

TAKAFUL According to ISRA (2012:512), the contributions paid by the participants are credited into the general takaful fund, which is then invested and the profits generated are paid back to the fund and eventually to the participants in accordance with the terms of the contract in a pre-agreed upon ratio after deducting operational costs.

TABARRU Tabarru is an agreement by a participant to relinquish, as a donation, a sum of contribution that he or she agrees to pay with the purpose of providing mutual indemnity to takaful participants, where the donation acts as a mutual help and joint guarantee should any fellow participants suffer from a defined loss (ISRA, 2012: 514).

TABARRU There are two important pillars of tabarru, namely the absence of counter-value and the intention to perform tabarru.

For example, if a donor contributes with an expectation of a counter-value from the donation given, then the whole transaction will be perceived as an exchange (muawadah) rather than a tabarru contract (Al Huda CIBE).

TABARRU IN GENERAL TAKAFUL Tabarra is derived from the word tabarra'a, which means contribution, gift, donation, or charity.

The purpose of this contract is to give a favor to the recipient without any specific consideration in return (Al Huda CIBE).

Essentially, tabarru is a contribution or donation, which entails no return, but rather a reward from Allah alone.

CONVENTIONAL INSURANCE Conventional insurance is based on exchange (muawadah), aims at making profit from the insurance operations, and is not Shari'ah compliant due to excessive gharar (uncertainty), maysir (gambling), and riba (interest).

TABARRU IN GENERAL TAKAFUL A takaful contract cannot be considered a pure tabarru contract, but rather a qualified or conditional tabarru contract due to the following reasons:

(1)The contribution made by a participant in takaful is with consideration to a right to claim for compensation in the event of loss or damage of subject-matter.

Thus, the tabarru is not merely for charity, but conditional upon certain consideration, namely the right to claim takaful benefits in the event of loss. This is a violation of the fundamental objective of tabarru.

TABARRU IN GENERAL TAKAFUL (2) Takaful participants are normally obliged to pay different amounts of contributions depending on the different degree of risk exposure.

This implies that their participation in the fund is conditional upon a certain amount of contribution, which deserves compensation.

This is in contradiction to the principle of tabarru as the real intention of the contracting parties is not for donation, but rather to make them eligible for certain benefits under takaful.

TABARRU IN GENERAL TAKAFUL (3) Takaful includes a few controversial practices such as surrendering of benefit, survival of benefit, or sharing of underwriting surplus among participants of takaful although they have surrendered all of their rights over the monies of the fund.

TABARRU IN GENERAL TAKAFUL (4) Furthermore, when a participant pays a premium to the takaful operator, he has effectively donated his contribution as tabarru, hence, relinquishing his ownership over the object donated as prescribed by the rules of tabarru.

Therefore, it should not return to the participants upon maturity of the policy or liquidation of the fund (Al Huda CIBE).

TABARRU IN GENERAL TAKAFUL The fundamental structure of takaful, which is premised on the basic concept of tabarru, is questionable as many benefits are offered to the participants in the beginning of the takaful contract in return for the contributions paid to the tabarru pool managed by the takaful operators (Revisit the Principle of Tabarru in Takaful Structures).

CONVENTIONAL V ISLAMIC INSURANCE Return on Investment (ROI)

The funds remaining in the takaful fund on maturity of the policy are distributed back to the participants after deduction of the charges due to the operator and according to the type of takaful management model utilized by the fund.

If the Takaful fund goes into deficit, the takaful operator can provide an interest free loan (Qard Hassan) into the fund.

QARD HASSAN In a situation where the takaful fund is not able to meet its current and future obligations, the takaful operation will be deemed insolvent (i.e. the takaful fund has less assets than liabilities).

The term solvency means the financial ability to pay debts when they become due. The fund’s inability to pay claims is contrary to the intent of the participants in joining the scheme and hence, a primary objective of everyone concerned is to ensure that fund solvency is maintained at all times.

QARD HASSAN The takaful operator plays an important role that the management of a conventional mutual does not play in the event of a periodic deficit in a takaful fund that exceeds the reserves of the fund, thereby making it potentially insolvent.

In this case, the takaful operator acts as a lender of last resort by providing a qard hassan loan to the takaful fund.

Such a loan will be repaid out of future underwriting surpluses.

QARD HASSAN However, the terms and conditions of repayment are often unclear and sometimes not stipulated.

In the event of non-recovery of a qard hassan, is the takaful operator willing to write it off as the deficit increases?

What will happen to the qard hassan in the event of insolvency?

QARD HASSAN From the operator’s perspective, the qard hassan is a temporary injection of operator capital into the risk fund and is a particular use of the operator’s capital (which ultimately comes from the shareholders of the operator).

There is an opportunity cost for the takaful operator when the operator’s capital is used for qard hassan.

It is the availability of affordable capital (either for the takaful operator to inject into the takaful fund as qard hassan or as the surplus available in the takaful fund, which is not locked up to ensure continuing solvency) that determines the speed at which a takaful business can grow.

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.

As a qard hassan is considered a loan injection into the takaful fund, repayment of such loans should take precedence over surplus distribution to participants.

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.’

QARD FACILITY 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.

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.

QARD FACILITY 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.

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.

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 FINANCIAL REPORTING 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 FINANCIAL REPORTING 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 FINANCIAL REPORTING 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 FINANCIAL REPORTING 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.

CAPITAL ADEQUACY REGULATION 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.

RBC FRAMEWORK MALAYSIA In Malaysia, a RBC framework has been implemented in the conventional insurance industry since 2009.

A RBC framework for Malaysia was intended to be implemented in 2012/2013.

The proposed RBC Framework for Takaful Operators will apply to all Takaful and Retakaful Operators registered under the Takaful Act 1984.

RISK-BASED CAPITAL Risk-based capital is used to set capital requirements, bearing in mind the size and degree of risk taken by the insurer.

It is the capital required to cover the risks the company undertakes. It is derived from the evaluation of different risks.

It is the amount of capital that needs to be covered by the assets of the business.

PROPOSED RBC FRAMEWORK FOR TAKAFUL OPERATORS MALAYSIA The Framework requires the maintenance of adequate capital at levels commensurate with the risk profile of the takaful operations to act as a financial buffer against any exposure to risks.

It is the takaful operator’s fiduciary duty to manage the capital and risks prudently, and in line with the objectives of Shari’ah.

Notwithstanding, the amount of minimum paid up capital or excess of assets over liabilities required for a takaful operator to operate takaful business in Malaysia remains unchanged.

PROPOSED RBC FRAMEWORK FOR TAKAFUL OPERATORS MALAYSIA In takaful, the concept of RBC is applied on the understanding that it is the takaful risk fund (representing all participants as a single collective fund) that needs to have sufficient assets to meet minimum solvency or RBC requirements.

Under the new Framework, the regulators, based on their assessment of a takaful product design or features, may require takaful operators to establish other funds to clearly reflect the specific nature, purpose or risk of a component of the contribution or other elements of the takaful product.

PROPOSED RBC FRAMEWORK FOR TAKAFUL OPERATORS MALAYSIAThis is intended to protect the interest of the participants, the soundness of the takaful funds and where appropriate, to reflect Shari’ah requirements.

Given the requirement for the takaful operator to extend a qard hassan in the event of a fund in financial distress, the Framework is designed to ensure that the takaful operator has the appropriate amount of capital to meet the qard obligation as well as to support its business operations.

PROPOSED RBC FRAMEWORK FOR TAKAFUL OPERATORS MALAYSIA Each takaful operator is therefore required to maintain adequate capital in its shareholders’ fund to support its business.

For this purpose, the capital available in the fund will be recognized in the capital adequacy measurement of risk by the takaful operator to the extent that this is consistent with the underlying responsibility and ownership of the various funds in the takaful business.

PROPOSED RBC FRAMEWORK FOR TAKAFUL OPERATORS MALAYSIA To this effect, the Framework provides incentive for the takaful operator to build a strong risk fund, thus reducing the amount of capital needed to be held by shareholders to support potential qard hasan obligations.

PROPOSED RBC FRAMEWORK FOR TAKAFUL OPERATORS MALAYSIA In the case of a takaful business, the CAR measures the adequacy of the capital in the shareholders’ and takaful funds to support the total capital required for the takaful business.

The CAR is the ratio of the business’s capital to its risks.

Capital Adequacy is the key indicator of the takaful operator’s financial resilience and will be used to determine the appropriate level of supervisory interventions by the regulatory authorities.

CAPITAL ADEQUACY RATIO CAR =Total Capital Available (TCA) x 100%

Total Capital Required (TCR)

PROPOSED RBC FRAMEWORK FOR TAKAFUL OPERATORS MALAYSIA The Malaysian regulators’ approach of pre-emptive intervention means that supervisory action is taken in the early stages of a takaful operator’s financial difficulties.

To do this, they have set a supervisory target capital level of 130%, below which supervisory actions of increasing intensity will be taken to resolve the financial problems of the takaful operator.

The takaful operator is then required to establish a higher internal individual target capital level.

PROPOSED RBC FRAMEWORK FOR TAKAFUL OPERATORS MALAYSIA The regulator will assess whether this target capital level is appropriate for the takaful operator’s risk profile and risk management practices; if it is not, the operator will be required to make adjustments.

PROPOSED RBC FRAMEWORK FOR TAKAFUL OPERATORS MALAYSIA A takaful operator will not pay shareholders dividends if its CAR position is less than its individual target capital level or if the payment of dividend will impair its CAR position to below its individual target capital level.

THE END