Takaful: 1,400 Years in the Making

September 29, 2010 by Philip Cook

Most of us in the insurance industry endorse some form of Code of Ethics, perhaps through our trade association, our employer, our graduate organization, or simply our own personal belief system.

Those “codes” generally deal with our relationship to each other, how we treat our customers and employers, and how we conduct our various business activities. The penalty for failure to meet those codes can range from a reprimand, a professional sanction or even loss of employment.

Now consider a situation where the Code of Ethics applies to all parties to a contract, including the conduct of policyholders and overlay that with the ultimate sanction of potential “divine retribution” and you begin to understand the basis of Takaful.

Takaful, literally meaning “mutual co-operation” has its origins in Islamic tradition, as expressed in the Qur’an and expanded or clarified by various prophets, scholars, clerics and community leaders (Imams) over the last 1,400 years. Its basic principles are:

co-operation between policyholders,
policyholder “subscriptions” to help those in need of assistance,
sharing of losses by a community pool, and
no unfair advantage to be gained by one party at the cost of others.

Added to these premises are three fundamental principles found in Sharia Law which apply to most Takaful transactions. They are:

the elimination of uncertainty (“Gharar”),
a prohibition against gambling (“Maisir”), and
a prohibition against charging interest (“Riba”).

All of these principles apply to transactions between policyholders and their Takaful insurers, but also to the business relationship between Takaful insurers and Takaful reinsurers (ReTakaful), and their retrocessionaires where applicable. When you combine all of these principles you quickly understand that the Takaful process is very different to what most of us are familiar with in our current insurance activities.

Takaful Development
Over the last 20 years, the growth in Takaful dedicated insurance companies has been substantial. At the recent 2010 meeting of the Annual World Takaful Conference, it was announced the annual growth in Takaful “contributions” (premiums) during 2009 was just under 40%, and it is expected to grow approximately sixfold over the next decade.

Most of this phenomenal growth to date has, not surprisingly, taken place in countries with large Muslim populations, but that is beginning to change. The world’s 1.5 billion Muslims obviously comprise a very substantial potential market, but they also represent a younger and evermore affluent society. This group is becoming increasingly mobile, so the Takaful concept is being exported to other countries and its ethical concepts are finding support from a growing number of non-Muslim customers.

There are currently more than 125 dedicated Takaful insurers operating in approximately 30 countries around the world and many of the larger conventional insurers have added Takaful divisions to their organizations.

Canada of course represents a significant potential market for the Takaful concept and although we do not yet have a fully dedicated Takaful insurer, several conventional insurers with Takaful divisions are already operating in Canada.

Takaful Explained
Let’s look at some of the principles behind Takaful to fully understand the differences. The most obvious are the “sharing” concept and the prohibition against “profit” at all levels of the insurance transaction.

Takaful policyholders pay their contribution (premiums) based on a fairly traditional actuarial calculation of the potential exposure to the pool of policyholders. However, the actuarial assessment of exposure does not include a “profit” ingredient, concentrating rather on pure loss cost, plus a small operating expense to cover the cost of maintaining the organization.

Implicit in all of these relationships is the assumption that each party will deal fairly with the other–remember utmost good faith?

Of necessity, the actuarial evaluation must be quite conservative so as to accumulate sufficient contributions to cover all reasonable loss expectations for any particular policy period. In some cases, the contributions are split between “own risk” and “pooled risk” to allow some risk differentiation at the primary (policyholder) level. In either case, any balance remaining in the pool at the end of the policy period, after allowing for incurred but not reported (IBNR) and normal reserve development, is returned to the policyholders.

Conversely, should there be insufficient funds available to cover the incurred losses in any given policy period, the policyholders are expected to contribute additional pro-rata amounts to cover the shortfall. While this theoretical contingency certainly exists, the credit risk is obviously a cause of concern for both regulators and the Takaful operators themselves, which demonstrates why the actuarial valuation of contributions (premiums) must remain very conservative.

The same “sharing” and “no profit” concepts apply to Takaful insurer-reinsurer relationships. Therefore, the reinsurance contracts must contain the same top-up and profit-share provisions.

Implicit in all of these relationships is the assumption that each party will deal fairly with the other–remember utmost good faith? This means the policyholder is assumed to be telling the truth, the contract should never contain uncertainty, and the insurer is simply acting as a facilitator to make sure the losses of the few are covered by the contributions of all pool members.

The above model is referred to as “Mudharabah” (profit sharing) and probably represents the purest form of mutual co-operation. Capital is generated through the contributions of the policyholders but profit or retained surplus also belongs entirely to the policyholders. Under this model, both the underwriting profit and investment income are part of the profit or surplus to be shared by the policyholders, and all expenses are pro-rated among the policyholders before profit is calculated and paid out.

Another model is referred to as “Wakalah” (agency) whereby a pre-agreed portion of the contributions (premiums) is allocated to service providers, and/or capital suppliers, based on their respective exposures. Under this model, all profit or retained surplus still belongs to the policyholders, but the calculation to arrive at those amounts allows the pre-agreed fees of the service providers and/or capital providers to be deducted and paid to them first.

Such fees, if agreed in advance, can also be adjusted to reflect underwriting performance of the portfolio within the constriction of no one party gaining an advantage at the cost of another. It should be noted that capital providers cannot charge “interest” on their investment, but their pre-agreed fees may contain an element of success-based return.

Takaful and Brokers
So how does all of this impact the Canadian broker community and what should you do to prepare for the changes that are coming?

First, it would be prudent to maintain a basic understanding of the Takaful concepts. Then, it would be worthwhile to identify markets within your current slate of companies that have Takaful divisions or are, at least, Takaful-friendly. You would also be well advised to watch for new Takaful entrants to the Canadian insurer community, particularly if your own target customer base contains a significant percentage of policyholders who may be attracted to the Takaful concept.

Another thing to keep in mind is that many of your newer customers and future prospects may be immigrants, or new Canadians who come from countries where Takaful is the predominant insurance system, or at least a significant part thereof. This will require you to provide some education on the differences, and probably a fairly detailed explanation of the “profit” ingredient inherent in conventional insurer premium calculations.

It is difficult to predict how quickly Takaful will expand in Canada, but based on its growth in other countries it is likely to develop exponentially once it actually gains a foothold.

And, as with the introduction of any new product, there is no substitute for being prepared for it in advance. However, unlike most other new products, the Takaful concept has some 1,400 years of history available for review.

Philip Cook is CEO of Omega Insurance Holdings Inc, which operates two subsidiaries in Canada. One is Focus Group Inc, an international insurance consulting and management company founded in 1986 and the other is Omega General Insurance Company, a federally licensed insurance company established in 2004.

This story was originally published by Canadian Insurance Top Broker.