Emphasis: Takaful -- Islamic Insurance Stands Test of Time

By Stuart Thompson and Mark Flower

Islamic finance, or finance consistent with the principles of Islamic law, has experienced significant growth in recent years. What was, until recently, a specialist area mainly in Muslim countries, now attracts such major international players as HSBC, ABN Amro and Deutsche Bank. The range of products extends from mortgages and bank accounts to multibillion-dollar Islamic bonds (sukuk). According to the Financial Times, estimates of the size of the current market range from $250 billion to $750 billion.

Islamic insurance, or takaful, has been slower to develop but has now grown sufficiently to attract major reinsurers such as Swiss Re, Munich Re and Hannover Re. In 2006, AIG set up AIG Takaful, based in Bahrain, to sell both life and non-life products.

With a global Muslim population of well over one billion, there is considerable room for this specialized version of insurance to grow, including opportunities for markets in the Western industrial countries.

The Current Takaful Market

The first takaful insurance company was established in Sudan in 1979. By 2004 (the latest year for which detailed statistics are available), the total gross written premium (GWP) for takaful business (life and non-life combined) had grown to just under $1.4 billion.

The 2006 ARIG Islamic Directory claims to be the first-ever directory of takaful companies around the world. It lists 75 companies with summary financial information for many of them through year- end 2004. While this is somewhat dated and does not contain financial information for all 75 participants, it does at least offer a window into this developing market. Exhibit 1 shows the distribution of business by country.

The International Cooperative and Mutual Insurance Federation (ICMIF) also publishes a guide on takaful operators. It lists:

• 77 takaful companies
• eight re-takaful (reinsurance) companies
• five conventional insurers offering a takaful window.

The takaful markets are primarily domiciled in Middle and Far Eastern countries. Saudi Arabia is the foremost country hosting takaful companies, with Bahrain, Malaysia and Sudan tied in second place. Together, the four countries accounted for roughly 75% of all takaful institutions between 2002 and 2004, according to the ARIG directory. In contrast, Europe and North America share less than 1% of the takaful market.

From the available data, we expect the majority of market participants to exhibit these features:

• Approximately 80% to 90% of the premiums go for general takaful, with the balance going for life (family).
• Annual GWP averages around $10 million to $20 million per company.
• Nearly half the gross written premiums are ceded to reinsurance or re-takaful, but this proportion is gradually declining.

 Principles of Islamic Insurance

Takaful insurance complies with Islamic law, or sharia, which derives primarily from the Holy Koran and the sayings and deeds of the Prophet Muhammad, but the conclusions of Muslim scholars are important secondary sources. An Islamic insurance company will usually appoint a board of recognized scholars who will monitor the company’s insurance products, investments and management practices to ensure that they remain compliant with sharia law. The growth of Islamic finance has led to a shortage of qualified sharia scholars with relevant international experience.

The key concepts of Islamic law applied to insurance are set out in Exhibit 2.

Obviously, conventional insurance would not satisfy these principles. However, in 1985, the Islamic Fiqh Academy ruled that insurance is acceptable to Islam if it operates through mutual self-help and cooperation, an important social tenet of Islam. Takaful, which derives from an Arabic word meaning "guaranteeing each other," is insurance that works on a mutual model. Policyholders (or participants) pay contributions (tabarru) into a fund where the group voluntarily shares risks collectively so that participants who suffer insured losses can receive compensation from the fund. Any surplus in the fund, which is not retained as reserves, must either be returned to participants or paid as a charitable contribution (zakat). Zakat is one of the five principle obligations of the Islamic faith.

While it is possible to operate a takaful business on a purely mutual basis, most recently formed companies operate as commercial entities that aim to make profits by operating a fund. The fund manager is also responsible for providing solvency capital. If a deficit arises in the fund, then it is made good by an interest-free loan (qard hassan), usually from the operator. This loan is repaid from any future surpluses, but if these are insufficient, then any losses fall on the operator.

There are two principal ways in which the operator is remunerated for the services and risk bearing provided:

• Mudaraba model: The operator receives a defined proportion of the profits of the takaful fund.
• Wakala model: The operator receives a defined fee from member contributions, or tabarru, and from the takaful fund itself.

Historically, the mudaraba model has been preferred in Southeast Asian countries such as Malaysia, while the wakala model has prevailed in the Middle East.

Mixed models are also possible. For example, it's possible to have a wakala model for underwriting and a mudaraba model for investment management. Whatever model is adapted, total transparency is required as to the level of fees and the basis for sharing profits.

Exhibit 3 illustrates a non-life takaful operation using the wakala model. Assets of the operator and participant funds are invested in sharia-compliant investments, avoiding riba and other prohibited activities. The mutual structure of the takaful fund allows any gharar to be “forgiven.” The sharia board of the company will monitor all activities including investments, policy wordings and other literature, and distribution of surplus to policyholders in a manner that complies with Islamic law. The operator will earn a profit to the extent that wakala fees exceed the costs of running the participants' fund.

A similar structure can be used for life (or family) takaful. Tabarru are paid into a participants' fund and invested in sharia-compliant assets. Life insurance and other risk benefits can be provided by risk deductions from the participants’ fund and are paid into a separate risk fund with any underwriting surplus returned to the participant’s fund. The structure is similar to that of universal life contracts offered by some Western insurance companies.

Takaful Success in the East

Takaful insurance is now a significant part of the developing insurance markets in Southeast Asia and the Middle East and can reasonably be expected to grow rapidly as these markets develop. For example, according to the Islamic Finance Review, the market for the Gulf Cooperation Council (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE) has been projected to exceed $15 billion by 2010. These markets are relatively undeveloped and should provide opportunities for multinational reinsurers and direct writers.

Opportunities in the West

Although the takaful insurance business to date has been confined mainly to Africa, Southeast Asia and the Middle East, there are now substantial Muslim populations in many Western European and North American countries (see Exhibit 4).

Sharia-compliant banking and mortgage products are increasingly available to meet the needs of these Muslims, and several organizations have begun to investigate the possibilities of providing takaful products. Since most Western countries have well- developed and highly competitive conventional insurance markets, takaful will be targeted at a small segment of the market. Success will require:

• A deep understanding of the local conventional insurance market and of the socioeconomic profile of the local Muslim population.
• The ability to design and sell profitable products at prices that compare reasonably in price with conventional insurance products while reflecting both the additional costs of sharia compliance and the specific risk characteristics of the target Muslim population. Currently, the penetration of takaful in those Muslim countries where both Islamic and conventional insurance are offered is often low, suggesting that takaful cannot sustain a significant premium price. This is supported by the current unpopularity of Islamic banking products in Western countries, where they are often perceived to be expensive. Thus, success is most likely to come in areas where the target Muslim population offers a lower risk than the population as a whole, but in a market where the lower risk is not reflected in the rating of conventional insurance products. If such areas cannot be identified or, if the Muslim population has a worse than average risk experience that is not priced into conventional products, then it may be very difficult to be both competitive and profitable.
• A medium- to long-term view for obtaining a return on capital. Many Western Muslim populations are, at present, predominantly first- or second-generation immigrants with lower than average wealth and younger than average age. This is especially true in Western Europe. It could take many years to develop a profitable Muslim insurance market as the target population matures.

A further challenge is to fit products structured to conform with principles of Islamic finance into Western financial and fiscal regulation. Here, considerable progress has been made in the banking area. The Islamic Financial Services Board and the International Association of Insurance Supervisors (IAIS) have set up a joint working group to consider the application of existing IAIS core principles to takaful. An issues paper published in August 2006 reviewed the applicability of each core principle to takaful and set out proposals for further work in developing standards and guidelines for takaful.

Meeting the Insurance Need

Although takaful has served as a widely accepted form of insurance in the Muslim world for many centuries, it clearly remains in an early stage of development as a recognized business offering in Western countries. It nonetheless offers an important additional means for meeting the insurance needs of Muslims throughout the world, including those in the West. Given its success to date, with more time and product design work, along with increased acceptance among regulators and customers, there is reason to believe it will expand in selected markets in Western countries. Takaful also, conceivably, stands to gain in appeal in Muslim countries where alienation from secular institutions is growing, along with interest in Islamic practices that are perceived to be devoid of Western influence.

Takaful: Deep Roots in Islamic History

Takaful is a form of insurance consistent with rules and practices of Islamic law, or sharia. Historically, it is grounded in Islamic banking practices and, as a concept, has been practiced in various forms since the early origins of Islam over 1,400 years ago. In Islam, one of the fundamental ideals is the notion that Muslims comprise a community whose members must treat each other with fairness and dignity -- an obligation that extends to all aspects of daily life, including business transactions. A related ideal is that Muslims should help and protect one another. Takaful fits with these spiritual precepts, deriving from an Arabic word meaning "to guarantee each other," or "to vouch for someone."

According to Wikipedia, the principles of takaful are as follows:

• Policyholders cooperate among themselves for their common good.
• Every policyholder pays his subscription to help those who need assistance.
• Losses are divided and liabilities spread according to the community pooling system.
• Uncertainty is eliminated with respect to subscription and compensation.
• No advantage can be derived at the cost of others.

The International Cooperative and Mutual Insurance Federation (ICMIF), based in London, supports the development of takaful arrangements in Muslim and non-Muslim countries. In October 2002, the ICMIF board of directors approved a statement saying the principles of takaful are in line with the organization's philosophy.

For comments or questions, call or e-mail Stuart Thompson at 44 20 7170 2431, stuart.thompson@towersperrin.com or Mark Flower at +44 (0) 20 7204 6000, mark_flower@gallagherre.com.