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PhD and MIF Programs

Project Paper

An Overview of Takaful in Malaysia

Corporate Finance
FN 5033/6033
Professor Dr. Shamser Mohamad
September 2012- Semester

Name Student ID Programme

Mace Abdullah 1000491 PhD


Yerkebulan Amanbayev 1100079 MIF
Gamal Salih Omer 1200073 PhD
Ahamed Elobied 1200074 PhD

Page 1
Abstract

Takaful is the Islamic alternative to insurance; it is not insurance per se. The Arabic word for
insurance is tamein, which means to reassure or guarantee through indemnification of losses.
Conventional insurance uses voidable (fasid) contracts called policies through which
individuals or firms receive indemnification against losses. Conventional insurance
companies pool policyholder risks in a form of risk intermediation. Each bilateral policy is
privately owned. Takaful, by contrast, not only pools risks, but also pools funds through the
use of unilateral contracts that are Shariah-compliant. Takaful is not what it purports without
compliance with its religious norms and prohibitions. Although Takaful must still be regarded
as nascent, it has shown remarkable growth in Malaysia. As Takaful grows it will inevitably
intersect with insurance, aspiring to replace insurance as the preferred mode of risk
intermediation. However, Takaful will need to answer many questions along that arduous
trek. Can Takaful compete with conventional insurance in the areas of risk management,
financial performance and innovation? Will Takaful adhere to its epistemology along the
way, or will it mimic conventional insurance? Malaysia is a world leader in Takaful. The
answers to these questions may well be answered in Malaysia. This paper analyzes recent
financial data, Malaysias regulatory and oversight regime, Takafuls risk profile and other
factors to draw an analytic picture of Malaysias Takaful industry.

Key terms of the research

Takaful, Insurance, Takaful risks, Insurance risks, Malaysian Takaful, Takaful financial
intermediation

Objectives of the research: The objectives of this analytic research are to:

Assess the development of Takaful in Malaysia


Compare Takaful with conventional insurance in Malaysia
Compare Takaful in Malaysia with Takaful worldwide
Identify Takafuls risk profile
Evaluate Takafuls financial role in Malaysia
Examine Takafuls financial performance
Discuss Takafuls growth prospects
Assess the future of Takaful in Malaysia

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Table of Contents

I. Introduction
A. Epistemology
B. Historical Background
II. Shariah Norms and Prohibitions
A. Distinctions from Conventional Insurance
B. Shared Attributes with Conventional Insurance
III. Takaful in Malaysia
A. Evolution & Development
B. Current Status
C. Organizational Models
D. Malaysian Classifications
E. Taxation in Malaysia
IV. Regulatory Oversight & Standard Setting
A. Legislative History
B. Bank Negara Malaysia
C. Islamic Financial Services Board (IFSB)
D. Accounting Association of Islamic Financial Institutions (AAOIFI)
E. Role of Shariah Boards & Committees
F. Fatawah
V. Risk Attributes of Takaful
A. Risk Profile
B. Risk Intermediation
C. Retakaful
D. TIPS
VI. Financial Attributes of Takaful
A. Financial Intermediation
B. Capital Structure
C. Growth Patterns
VII. Conclusion & Findings
References

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I. INTRODUCTION
A. Epistemology1
Islamic financial institutions have a collective religious obligation (fard kifayah)
imposed upon them by the Shariah. This obligation includes the necessity for Shariah-
compliant financial intermediation in a Shariah-compliant manner. It mandates the need to
preserve wealth and mitigate harm (Farook 2007). Takaful, as a key Islamic financial
institution, has religious obligations concomitant with its roles in the Islamic financial
system. Technically, its primary roles are risk mitigation and financial intermediation.
Religiously, its primary roles are social wellbeing and mutual assistance. These roles must be
reconciled periodically to insure that Takaful retains its pristine purpose.
Takaful is firmly grounded in religious commands (talab) and obligations (ijab). Yet
Takaful is not explicitly prescribed in Shairah, i.e. by name. Rather, mutual support and
assistance are commanded and are fundamental to Islamic social wellbeing and the Islamic
financial system. Almighty Allah advises those who believe (mumineen):
"O you who believeassist (taawanu) one another in birr (the doing of good)
and taqwaa (having consciousness of Allah). Assist not one another in sin and
transgression, but keep your duty to Allah" (Quran 5:2)2.
Islam requires brotherhood and solidarity among believers and steadfastness against
those who seek to cause harm; economically or otherwise. Almighty Allah advises the
believers:
And hold fast (cling) to the rope (habl) of Allah all together (jamiaa) and do not
be divided (Quran 3:103).
The Arabic word habl has etymological meaning of a promise of assurance, security, or
safety and a thing well known to which one clings, causing unity (Lane 1863). In short, it
implies solidarity.
The importance of solidarity among the believers has been emphasized by the
Prophet, AS3. Abu Musa, RAA4, reported Allah's Messenger, AS, as saying:
A believer is like a brick for another believer; the one supporting the other
(Sahih Muslim, Bk. 32, #6257).
And he emphasized the common interests and shared concerns of believers, when he said:
You will see the believers in regard to their mutual love, affection and
compassion, like the example of a single body; when any limb aches, the whole
body aches (Sahih Bukhari #6011 and Muslim #2586 with similar phrasing in
Musnad Ahmad).
These textual proofs of the call to solidarity and mutual assistance to stave-off harm
are buttressed by numerous legal maxims (quwaid al-fiqhiyyah) that support the common

1
Simply put, epistemology is the study of knowledge and seeks to distinguish between what we believe to be true
knowledge from that which we believe to be false knowledge.
2
References to Quran in this paper, refer to a translation by Muhammad Mohar Ali (former professor of History at
Madinah University and graduate of Imam Muhammad University, Riyadh, KSA), A Word for Word Meaning of the
Quran (Jamiyat Ihyaa Minhaaj as-Sunnah (Ipswich, Suffolk 2003).
3
AS is used throughout this paper stands for the prescribed salutation upon the Prophet of Peace be upon him.
4
Throughout this paper, the term RAA is in reference to the honor Muslims are instructed to give to the companions of
the Prophet, AS, i.e. Radhi Allaahu anhu or may Allaah be pleased with him.

4
responsibility of mitigating harm. For example: Hardship is to be alleviated (al-mashaqqa
tajlub al-tasysir) and Prevention of harm takes priority over securing of benefits (dar al-
mafasid awla min jalb al-manafi). (Kamali 2006).
Accordingly, Muslim scholars have concluded that among the ultimate objectives of
the Shariah is that of serving the interests of all human beings (jalb al-masaalih) and to save
them from harm (dafa al-mafasid). (Bouheraoua 2011). Preservation and protection of the
essentials of human beings is established under the Objectives of Islamic Law (Maqasid ash-
Shariah) as necessities of life (dururiyyat). These essential rights that are to be preserved
include the protection of: faith (din), life (nafs), family (nasl), intellect (aql) and property
(maal). Ibid.
Thus, Islam calls mankind to engage in mutual cooperation or assistance (taawun) in
preserving and protecting from harm those things deemed good, including property, family
and life itself. It is well established Fiqh, that (d)ifficulty begets facility; that is to say,
difficulty is the cause of facility and in time of hardship consideration must be shown
(Mejella, Article 17). And the command that Harm must be eliminated (adh dharar
yuzaal), which is another legal maxim derived from the Hadith narrated by Ibn Abbas, RAA,
that the Prophet, AS, said: Neither harm nor be harmed (laa dharar wa laa dharaar). (Ibn
Majah).
B. Historical Background
That Takaful has religious roots is undeniable. Yet, as is the case with other forms of
human dealings (muamulat), it also finds its genesis in early forms of mutual cooperation.
The Prophet, AS, saw some of these practices among the Arabs, e.g.:
Merchants of Makkah formed funds to assist victims of natural disasters or hazards of
trade journeys (museebah). This was a form of surety called damman khatr al-tariq
and was based on perceived risks of loss due to hazards on trade routes.
Contracts, called aqd muwalat, were entered into for bringing about an end to mutual
enmity or revenge.
Alliances were formed by means of hilf or confederacy agreements.
Assistance relating to the payment of blood-money or diyah was provided to
captives and the families of murder victims (qisas) through a tribal form of assistance
known as aqilah. (Obaidillah 2005).
It is aqilah from which Takaful can trace its Fiqh origins back to the time of the
Prophet, AS, wherein he rendered judgment on the doctrine of aqilah. The Prophet, AS,
being aware of this tribal practice, is reported to have used aqilah in his rulings as follows:
Narrated by Abu Hurairah (RAA), he said that once two women from Huzail clashed
when one of them hit the other with a stone which killed her and the baby in the
victims womb. The heirs of the victim brought an action to the court of the Prophet
(AS) who gave a verdict that the compensation for the foetus to be a male slave or
female slave while the compensation for the killed woman is a blood money (diyat) to
be paid by the aqilah (the relatives of the fathers side) of the killer. Bukhari, Vol. 9,
# 45.
And as noted by Obaidillah, the Sahifatul Madinah or Constitution of Madinah,
enacted by the Prophet, AS, assured certain forms of taawun or mutual cooperation would be

5
implemented and upheld. Obaidillah explains that it contained three (3) aspects of taawun,
including:
Provision for social insurance affecting the Jews, Ansar and the Christians.
Statement that "the immigrants among the Quraish shall be responsible for their
word and shall pay their blood money in mutual collaboration."
Provision for ransom (fidya) whereby payment is made to rescue the life of a
prisoner and the relatives (aqilah) could cooperate to free him.
Thus, the Prophet, AS, took a tribal custom and transformed it into a rule of law
(hukm ash-Shariah) for mitigating harm by and among the people. It can be seen from the
above that Takaful has its origin in customs or urf or abah of the Middle East. It can be said
that it is part of the Sunnah of the Prophet, AS, that he acquiesced in matters of urf or adah
that contained good in them (a form a Sunnah called Sunnatul taqririyyah or tacit approval).
(Kamali 1991).
Urf is an Arabic word that connotes knowing. It is established practices among
people (well known) that are deemed to be beneficial and for their wellbeing. One of its
characteristics is that it is communal and practiced throughout the society repeatedly and
continuously (OIC 1988). Thus, its prevalence is al-amm or general. It must have attributes of
being sound and reasonable. It may be verbal, but in this instance, the form being identified is
that of a practice (urf fili). (Nyazee 2004).
Urf cannot contravene the Shariah. As is the case, in general, with other forms of
muamulat, its starting point, absent a textual prohibition found in Quran and Sunnah, is that
of permissibility (mubah or ibahah). Later, such practices may be accepted by the Shariah,
either by judgment as can be seen from the Hadith of Abu Hurairah above, or by tacit
approval. Thus, we find the legal maxim: Custom (adah) is the basis of judgment (al-
'adatu muakkamtun). (Mejella Article 36).
II. SHARIAH NORMS AND PROHIBITIONS
A. Distinctions from Conventional Insurance
Takaful means guaranteeing each other in Arabic. Etymologically, its root comes
from the Arabic kafala; which is, of course, one of Islamic Finances intermediate
contracts. It is a system of Islamic insurance based on the principle of mutual assistance
(taawun) and donation (tabarru) where risk is shared collectively by a group of participants
voluntarily. This is a pact among a group of members or participants who agree to jointly
guarantee among themselves against loss or damage to any of them as defined in their
contracts.
Shariah Norms. Takaful has 5 key elements that normalize it for Shariah purposes.
They are self-explanatory, for the most part, and include:
Gratuitous mutual contributions and guarantee of losses divided between participants,
i.e. in which case the participants are both the insurer and insured and all participants
are aware that they face similar risks and are willing to contribute to the misfortune of
any member.
Ownership of the Takaful fund and retaining mutual (versus private) ownership
interests therein, including its profits.

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Avoidance of oppression (zulm), unfairness, injustice and exploitation (istighlal) and
an understanding that their affairs are to be conducted openly in accordance with the
utmost faith, good, honesty, transparency, truthfulness and equity.
Management of the Takaful fund through the use of Shariah-compliant contracts, e.g.
mudharabah or wakalah.
Investment conditions necessitate that all investments must be Shariah-compliant;
thus, prohibiting investment in impermissible or haram industries and requiring the
use of investment instruments that are Shariah-compliant.
Shariah Prohibitions. Conventional insurance contains three features that are
prohibited by the Shariah. They are:
Major Uncertainty (Gharar Fahish): Transactions should be free from excessive
uncertainty. Excessive, unacceptable uncertainty is caused by the lack of information
or disclosure (jahl), which leads to ambiguity (taghreer), lack of mutual consent
(ridha), misrepresentation (ghabn) or exploitation. Thus, making a contract of
insurance unduly complex, verbose or combining within it, two or more other
contracts, can easily lead to gharar. Misleading advertising and marketing
(khalabah) can lead to misrepresentation and exploitation of the unwary. All or some
of these characteristics in any commercial contract, including insurance contracts, can
render the contract defective and thus voidable (fasid5). Voidable contracts can still be
honoured and they may be reformed. This implies that they are not totally invalid, but
there is language or provisions in them that are unacceptable to Shairah. It should be
noted that more gharar is accepted in charitable, unilateral contracts (at-tabarruat)
than in purely commercial transactions. This latter Shariah principle buttresses the
validity of Takaful contracts.
Gambling (Maisir or Qimar): Gambling is not permissible under Shariah. In
gambling, one party is always hoping for a gain at the cost of another party loosing
(qimar); the so-called zero sum game. Alternatively, one party may hope or
gamble on a windfall or large gain with little or inordinately small counter-value
(maisir). In the context of insurance, the policyholder hopes (bets) to gain a large sum
from his small amount of contribution. What the policyholder actually hopes is that
the claim will exceed his contribution. Thus, pooling of interests helps to avoid
individual gain caused by individual greed or fraud. In this case, the company would
probably be in deficit.
However, the policyholder would lose the money paid for premium if the
insured event does not occur, e.g. with certain so-called term life policies. These
policies insure the life of the policyholder for a term of years; thereafter, the party is
left uninsured if (s)he outlives the term. Furthermore, only a proportional refund
would be made if the contract is terminated by the insurance company. Worse yet,
some conventional policies demand payment of the entire premium for the initially
insured period, even if the policy is terminated or forfeited by the insured.

5
Fasid means voidable in the majority of mudhahib (schools of religious law), but may mean invalid in the Shafiee
madhab.

7
Interest (Riba): Any insurance contract wherein the policyholder expects to obtain a
fix amount of profit that is greater than what he has contributed is considered as riba.
That is because, by and between him or her and the insurance company, there is an
exchange (and some might say an exchange of money), wherein one side lacks the
equivalent counter-value or consideration. Other Shariah violations occur if the
exchange is considered an exchange of money, and deemed bai as-sarf. Furthermore,
investing premiums in financial instruments that are not Shariah-compliant usually
involve prohibited elements of riba (e.g. interest) and maisir. Hence, the
conventional insurance is prohibited under Shariah on a variety of grounds
emanating from the prohibition against riba on all levels, i.e. shareholder,
underwriting and investment funds.
B. Shared Attributes with Conventional Insurance
Certainly, Takaful is an adaption of customs that were prevalent before the advent of
Islam. It has never been said that Islam is the first religion, but rather the completion or
fulfilment of that which came before it, in its pristine form (Quran 2:97). That said, the roots
of conventional insurance can be traced back to the Chinese. Around 5,000 BCE, Chinese
traders spread their merchandise over several ships, instead of putting all their property on
one ship. If one ship sank, no individual trader bore the loss. If two traders spread their
goods over two ships and one sank, each trader lost only half of his goods rather than
everything (CGU 2004). The Babylonians, in the 3rd and 2nd millennium BCE, also engaged
in insurance practices of risk transference and the latter codified such practices in the Code of
Hammurabi, circa 1750 BCE6.
These were early methods of transferring or distributing risk, practiced by Babylonian
and Chinese traders and early Mediterranean sailing merchants. Similarly, if a merchant
received a loan to fund his shipment, he would pay the lender an amount of interest much
higher than the market average in exchange for the lender's guarantee. If the shipment was
never received, the lender lost his money and the loan was considered cancelled (Ajmi 2005).
As has been shown, both Takaful and conventional insurance have connection to these
earlier practices, though different epistemologically. And it can be observed that insurance or
risk intermediation, by definition, is executor in nature. That is to say that the process of
sharing or remediating risk involves future obligations, whether or not they are undertaken in
a unilateral or bilateral context. This can be seen from the comparison of Takaful with
conventional mutual insurance. The former uses unilateral tabaruu contracts, while the latter
uses bilateral policies. Both seek to minimize future risks and thus result in unfulfilled or
executor contractual obligations. However, one must make some distinction between what is
known conventionally as mutual insurance and what can be called stock owned insurance.
The former is owned by the participants (as in Takaful), while the latter is owned by 3rd party
investors, whose primary motive for involvement with the insurance company is profit.
Table 1 illustrates the similarities and differences between the 2 models of
conventional insurance and Takaful. Dawood Taylor, Senior Regional Executive-Takaful
Middle East, of Prudential Corporation Asia, compared conventional mutual insurance with
Takaful at the World Takaful Conference in Dubai in 2010. The primary difference between

6
http://en.wikipedia.org/wiki/Insurance#History_of_insurance).

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Table 1-Comparison Between Conventional Insurance & Takaful
Characteristic Mutual Insurance Stock-Owned Takaful
Insurance
Contractual relationship Risk sharing by the Commercialized buy- Tabarru or unilateral
policyholder-owners within sell or exchange gratuitous promise to
the mutual company. contract. Such contribute, combined at times
Contracts are bilateral. contracts are bilateral. with wakalah (agency) and/or
mudharabah (partner) operator
agreements.
Economic goals Provide value to the Based on profit- Based on the motive of
policyholders-owners. motive to maximize community welfare, protection
Possible conflict of interest profit to shareholders. and mutual assistance; the
between board, managers and An inherent conflict presence of a 3rd party operator
policyholder-owners. of interest between or manager does not
shareholders, circumvent that primary goal.
managers and
policyholders..
Governance Board of directors and Boards of directors SAC, Shariah advisory
managers run the company "in elected by boards or committees and
trust" for policyholders. shareholders; boards of directors. Operators,
Policyholders have the right managers appointed as agents or partners must
to appoint board of directors, by board. adhere to Shariah,
and the board of directors governance and prudential
appoints management. principles.
Premium payments, surpluses Policyholders pay premiums Policyholders pay Contributions by participants
& profits to the mutual pool; surpluses premiums, which are are gratuitous and pooled, but
& deficits are allocated to the for specific insurance held in individual participant
accounts of policyholders; and coverage over a special accounts (PSA);
surpluses can be retained for specified timeframe; savings or investment feature
reserves against future claims. premiums may may be present in family plans
contain an investment and are placed in
feature; surpluses and individualized participant
income from accounts (PA); if no event
investments belong to before maturity, participants
the insurance receive the balances of their
company and the PA, PSA and proportionately
income from any valued share of surpluses;
investment feature is surpluses are wholly owned by
based upon a fixed participants unless wakalah
annuity type contract. and/or mudharabah operators
Taxes are paid on access as fees or profit
profits and dividends sharing. Zakat is paid on
to shareholders surpluses.
Liability of Mutual pool is liable on Underwriting claims Claims are made from PA and
Insurer/operator claims. are paid from PSA first. Then, from the
premiums collected, Takaful fund; in the case of
investment income deficits, qard hassan or a
allocable to the benevolent loan can be made
insurance companys by an operator to the fund.
capital or assets to
provide the face value
of coverage; insurance
company may finance
its activities with
conventional debt or
equity shares
proceeds.
Access to capital No access to share capital, but Insurance companys Access to capital of operator
possible use of subordinated capital is at risk. Debt through use of Qard Hasan.
debt. may be used.
Investment of funds No restrictions except for No restrictions except Resticted to Shairah-
those imposed for prudential for those imposed for compliant investments,
reasons. prudential reasons. including avoidance of gharar.
(Adapted from Taylor 2010) Permission granted.

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the two models is the epistemological origins and the Shariah norms and prohibitions related
to riba (Taylor 2010). Thus, it can be said that the differences with conventional insurance
practices is less significant with mutual insurance companies than with stock insurance
companies.
It is instructive to note that many, if not most, mutual insurance companies in the
West have de-mutualized and become stock-owned insurance companies. Apparently all that
is needed is a majority approval by the policyholders and approval by the regulator. Such
large insurance companies as Liberty Mutual, New York Life, Metropolitan Life, John
Hancock and Prudential, all started out as mutual insurance companies, but were
subsequently de-mutualized (Rambeck 2001). This would appear to be an area of inquiry for
research as Takaful grows and the most efficient models are compared, i.e. what makes one
form of operation more efficient or effective than another.
Insurance is permissible in Islam when undertaken in the framework of Takaful or
mutual guarantee and taawun or mutual cooperation. It is a pooling of unilateral promises
among a group of people with common interests to protect and guarantee each other from a
certain class of misfortune. It is based on sincerity and willingness of the group to help
anyone among them. The similarities with mutual insurance companies are remarkable.
However, Takafuls differences from conventional insurance are much starker when
compared to the commercialized aspects of stock-owned insurance companies. These
conventional insurance companies offer and sell protection at a certain cost or price and for
profit. Each contract is individual and the private property of the policyholder and the actual
owner of the policy may be someone who has an insurable interest in the inured person or
property being insured.
Because 3rd party investors and the managers they appoint may have the incentive to
maximize their profits at the expense of the policyholders, there is a stronger conflict of
interests between shareholders of the insurer company and the policyholders. Moreover, this
agency problem may also cause managers of the insurance company, who may have bonuses
or other forms of compensation tied to performance incentives, to minimize claim payments
or benefits, or to raise premiums in order to maximize profits.
Although Takaful funds do have 3rd party operators (who manage the fund on the
basis of wakalah or mudharabah), Takaful funds in Malaysia are subject to a regiment of
regulatory oversight and Shariah governance. Shariah governance is effectuated by the
standards applicable to Takaful funds promulgated by the Shariah Advisory Council (SAC)
of Bank Negara Malaysia (BNM). The Islamicity of the fund is safeguarded further by its
own Shariah advisory committee or board, which functions at the fund level to insure that
products, services and operational activities are Shariah complaint. Moral hazards, which
may arise in conventional insurance, are frowned upon in Takaful. Such moral hazards may
include the conflicts of interests discussed herein, agency problems, as well as zulm and other
unfair and undesirable features of commercial activities. Moreover, the emphasis placed on
Shariah governance in Malaysia particularly, illustrates the epistemological differences
between Takaful and conventional insurance.

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III. TAKAFUL IN MALAYSIA
A. Evolution & Development
In 1979, Sudan started the 1st Takaful fund, the Islamic Insurance Company of Sudan
(Ajmi 2005), a little more than a year after a fatwa by the Saudi Arabian Council of Head
Scholars (24/3/1977) denouncing conventional insurance contracts as being imbued with
gharar. Later that same year, the Islamic Arab Insurance Company of Saudi Arabia was
formed. (Ernst & Young 2012). Malaysian scholars quickly followed in 1982 by denouncing
life insurance contracts. Malaysia was already well along the way to an Islamic financial
system, when in 1963, Tabung Haji became the first Islamic institutional investor. The first
Takaful fund was started in Malaysia in 1984, one year after establishing its first Islamic bank
(Laldin 2008).
The development of the Takaful industry in Malaysia in the early 1980s was inspired
by the prevailing needs of the Muslim public for a Shariah-compliant alternative to
conventional insurance, as well as to complement the operation of the Islamic bank that was
established in 1983. It was, to a large extent, triggered by the decree issued by the Malaysian
National Fatwa Committee which ruled that conventional life insurance policies were fasid
due to the presence of gharar (excessive uncertainty), riba (usury) and maisir (gambling). A
Special Task Force was established by the Government in 1982 to study the viability of the
setting up of a Takaful fund. Following the recommendations of the Task Force, the Takaful
Act was enacted in 1984 and the first Takaful operator was incorporated in Malaysia in
November 1984.
Malaysian Takaful has experienced rapid growth and transformation since its
inception 28 years ago. It has grown from a single player with limited basic products to 12
Takaful and 4 Retakaful operators; all integrated into the mainstream financial system. This
was achieved through the concerted efforts of Bank Negara Malaysia (BNM) and the Takaful
operators in developing a dynamic, resilient and efficient Takaful industry. In developing
Takaful in Malaysia, BNM has adopted a gradual approach which can be divided into three
phases as shown below.
Phase I (1982-1992) started with the enactment of a dedicated regulatory law, the
Takaful Act 1984 (still the only statute globally that is fully dedicate to Takaful
undertakings), to govern the conduct of Takaful funds, and for the establishment of Shariah
committees to ensure that the business operations of a Takaful operator are in compliance
with Shariah principles at all time, and the establishment of the first Takaful operator in
1984Syarikat Takaful Malaysia. The primary focus during this period was the establishment
of the basic infrastructure.
Phase II (1993-2000) marked the introduction of competition with the entry of
another Takaful operatorTakaful National Sdn. Bhd. This period also saw greater
cooperation among Takaful operators in the region including the formation of the ASEAN
Takaful Group in 1995 and the establishment of ASEAN Retakaful International (L) Ltd. in
1997. This has facilitated retakaful (reinsurance) arrangements among Takaful operators in
Malaysia and in the region; namely Brunei, Indonesia and Singapore. It also saw the
appointment of members of the National Shariah Advisory Council for Islamic Banking and

11
Takaful. In addition to this, Takaful Malaysia and Takaful National (now known as Etiqa
Takaful) jointly developed a Code of Ethics in 2000.
Phase III (2001-2010) began with the introduction of the Financial Sector Master
Plan (FSMP) in 2001 which, among other objectives, is to enhance the capacity of the
Takaful operators and strengthen the legal, Shariah and regulatory framework. The section
of the (FSMP) which relates to Islamic banking and Takaful is a road map towards realizing
the aspiration of Malaysia becoming an international centre for Islamic finance. This period
has so far witnessed an increased pace of development and competition with the licensing of
new operators i.e. setting up of Ikhlas Takaful operator in 2002, issuance of four new Takaful
licenses between 20052007.
To further promote the development of Takaful, the Malaysian Takaful Association
(MTA), an association for Takaful operators, was established in 2002. The MTA aspires to
improve industry self-regulation through uniformity in market practices and in promoting a
higher level of cooperation among the players in developing the industry.
Also, during this phase, the Malaysian International Islamic Financial Center (MIFC)
was established in 2006 to develop intermediary linkages to the global market place. The
MIFC also promoted the liberalization of the Takaful Industry in 2009, which saw the
issuance of 4 new family Takaful licenses in 2010. These new Takaful players added
significant value to Malaysias development of Takaful. Moreover, given the push for the
introduction of more stringent capital requirements, Malaysia has extended the discussion on
risk based capital (RBC) to Takaful.
B. Current Status of Takaful in Malaysia
Takaful is now a core segment of Malaysias status as a worldwide Islamic Finance
hub. It is part of an end-to-end Islamic Finance system. Today, Malaysia has 12 Takaful
operators, 9 Malaysian (M) and 3 foreign-owned (F) owned:
AIA-AFG (F) Great Eastern (F)
ING Public (F)
AmFamily (M) CIMB Aviva (M)
Etiqa Takaful (M) Hong Leong MSIG (M)
HSBC Amanah (M) MAA Takaful (M)
Prudential BSN (M) Syarikat Takaful (M)
Takaful Iklas (M)
Also, there are currently 4 Retakaful operators, 2 Malaysian (M) and 2 foreign-owned (F):
MNRB Retakaful (M) ARC Re Takaful SEA (M)
Munich Retakaful (F) Swiss Re (F)
Worldwide there are less than 200 Takaful operators and less than 20 Retakaful
operators. Malaysia has 6 conventional life and general insurance companies; 2 are
Malaysian and 4 are foreign-owned: Etiqa (M), MCIS Zurich (M), AIA (F), ING (F),
Prudential Assurance (F) and Zurich Insurance Malaysia (F). There is 1 conventional
reinsurance operator and it is foreign-owned, i.e. Hannover Ruechversicherungs AG (F).
However, as will be shown later, Malaysian Takaful contributions still lag far behind
Malaysian conventional insurance premium. As can be seen, some of the conventional

12
players have opened Takaful operations, utilizing their resources and insurance expertise to
seize the Takaful opportunities.
In Malaysia, Family Takaful is larger, but General Takaful is gaining traction. As of
2011, Takaful contributions were about .6 of 1% of Malaysias Gross National Income and
approximately 10% of total insurance premiums (BNM 2012). Worldwide, Takaful is a
projected $12 billion dollar industry in 2012, according to the most recent Ernst & Young
(E&Y) World Takaful Report; after being $8.3 billion in 2011 (after adjustment for inflation).
Conventional insurance worldwide is a $4.6 trillion dollar industry by comparison (Ernst &
Young 2012).
C. Business Models
Takaful operators use several different models to fulfill their roles as providers of
Takaful. The primary models are named after their underlying secondary contracts under the
Islamic Finance system. They include tabarru, wakalah, mudharabah, waqf and the hybrid
models (Alhabshi 2012).
Tabarru (Donation) -Based Takaful. The tabarru-based Takaful is the most ideal
model of Takaful among other models. Initially, Takaful was seen as a non-profit oriented
activity. This model is based on solidarity, responsibility and brotherhood among
participants. In this model, each participant is willing to make donation to the Takaful fund
with sincere intention to extend financial assistant to other participants faced with difficulties.
It provides no return for both the Takaful operator and the participants. Therefore, such model
is viewed as impeding large-scale expansion of Takaful business (Ibid).
Mudharabah-Based Takaful. Mudharabah is an Arabic term that comes from darb
fil-ard, meaning to journey through the earth seeking the Bounty of Almighty Allah. Under
this model, the participants make contributions that are credited to a participants fund, while
the shareholders of the Takaful operator company contribute to a shareholders fund which is
different from the participants fund. The Takaful operator, as mudharib, invests the
participants fund in Shariah-compliant instruments. Profits generated from the investment
are shared between the participants and Takaful operator in the agreed ratio. Any losses are
charged to the participants fund. In a mudharabah concept, operational expenses relating to
investment are charged to the shareholders fund. In managing the operations, general and
administrative expenses other than relating to investments are charged to the participants
fund. As valid claims are made, Takaful benefits are paid to beneficiaries depending upon
occurrence of actual losses and damages. In case of surplus, the participants receive full
refund, but have to make additional contributions if a deficit exists (Ibid).
Wakalah-Based Takaful. Under the wakalah-based model, the Takaful operator
performs as the wakil or agent of the participants and is consequently entitled to a fee for the
services provided. In theory, the participants contributions are credited to a participants
fund. As an agent, the shareholders of the Takaful operator company donate to a
shareholders fund which is maintained separately from the participants fund. The Takaful
operator invests the participants fund in Shariah-compliant instruments in its capacity as
wakil or agent. All operational general and administrative expenses are charged to the
participants fund. The Takaful operator receives an agency fee from a percentage of the
gross contributions received. As valid claims are occurred, the benefits are paid to the
participants depending upon occurrence of actual losses and damages. Any underwriting

13
surplus is given back to the participants. And the participants are required to make additional
payment of deficit if any (Ibid).
Waqf Model. Under this model, a waqf can be established by the Takaful operator
through the contribution of a ceding amount (part of the capital) to compensate the
beneficiaries or participants of a Takaful scheme. The ceding amount of the waqf will remain
invested. The Takaful fund, consisting of the contributions paid as tabarru, will be further
invested by the operator in accordance with Shariah. Any person by signing the proposal for,
contributing to the waqf and subscribing to the Takaful documents, shall become a member of
the waqf. The waqf will become owner of all contributions and has the right to act as a legal
entity as per its terms for investment, compensation and dealing with the surplus amounts.
The Takaful wakil, while managing the waqf fund, will play two different roles
simultaneously: operator/manager and trustee (Ibid).
Hybrid Model. The hybrid model combines elements of the wakalah and
mudharabah models and is set so that the Takaful operator has two funds; one for the
shareholders and the other for participants. In this model, a wakalah contract is used for
underwriting activities while mudharabah contract is used for investment activities. With
regard to underwriting activities, the Takaful operator acts as wakil or agent on behalf of
participants to manage their funds. In exchange for managing the funds, the Takaful operator
received a fee known a wakalah fee of agency fee which is normally a percentage of the
contributions by participants. An incentive fee is provided to the Takaful operator if there is a
surplus in the participants fund as a result of managing the fund effectively. Generally, any
surplus contributions will be invested in different Islamic instrument based on mudharabah
contract, which the Takaful operator acts as mudharib on behalf of participants (capital
provider). Like other mudharabah contract, the ratio of profit is fixed and agreed upon
between the two contracting parties (Ibid).
D. Malaysian Classifications
Takaful in Malaysia is broadly divided into Family and General Takaful.
Family Takaful Business. A Family Takaful plan is a combination of long-term
investment and a mutual financial assistance scheme. The objectives of this plan are as
follows:
To encourage saving on a regular basis over a fixed period of time.
To earn investment returns in accordance with Islamic principles.
To obtain coverage from a mutual aid scheme in the event of death of the
participant prior to maturity of the plan.
The contribution paid by the participant is credited into two separate accounts, namely the
Participants Special Account (PSA) and the Participants Account (PA). The portion of the
contribution that goes into the PSA is based on the tabarru or donation concept. The amount is
actuarially determined based on the age and overall health of the participant and the cover period.
The older the participant, the higher will be the portion of the tabarru. Similarly, the longer the
period of coverage, the higher is the tabarru'. The balance of the contribution after deduction for
tabarru' goes into the PA account, which is meant for saving and investments only.
The participants' contribution that goes into the PSA will be used to fulfill the obligation
of mutual help should any of the participants face misfortune arising from death or permanent
disability. If the participant survives to the date of maturity of the Takaful plan, he or she will be

14
entitled to share the net surplus from the fund, if any. The fund in the PA account will be invested
by the Takaful operator. The profit from the investment will be shared between the participants
and the operator according to a pre-agreed ratio (Ibid).
General Takaful Business. The General Takaful scheme is essentially for mutual
financial assistance on a short- term basis, usually 12 months. The scheme is mainly to allow
participants to be compensated for any material loss, destruction or damage to their properties or
belongings by some mishap or misfortune. Under this concept, all the contributions made by the
participants are placed in the General Takaful fund on the basis of tabarru' or donation. This is
quite different from Family Takaful where the contributions of the participants are divided and
credited into two separate funds, the PSA and the PA. If at the end of the Takaful period, a net
surplus exists in the General Takaful fund, the same shall be shared between the participants and
the operator on the basis of mudharabah (profit sharing), provided the participants have not made
claims or received benefits in excess of contributions. The main types of General Takaful scheme
provided operators are:
1. Home Takaful scheme.
2. Motor Takaful scheme.
3. Marine, aviation and transit Takaful schemes.
4. Accident /miscellaneous Takaful scheme, which includes:
(a) Personal accident scheme.
(b) Workmen compensation Takaful scheme.
(c) Engineering Takaful scheme (Ibid).
E. Taxation in Malaysia
It should also be noted that in Takaful, zakat should be paid on any surplus; regardless
of whether the fund is otherwise subject to income taxes. Generally, companies are taxed in
Malaysia as residents, if the management and control of the company is based in Malaysia.
Control, for tax purposes, is demonstrated by the holding of statutory board meetings in
Malaysia which concern management and control of the company. Resident companies with
paid-up capital of RM 2.5 million or less are taxes at a flat 20% rate for the first RM500,000
of chargeable income and a flat 25% rate for chargeable income in excess thereof (PWC
2012).
Non-resident companies are taxed at a flat 10% rate on royalties, rental income on
moveable properties and technical or management service fees rendered in Malaysia. A 15%
rate applies to interest income that is not exempt. Interest income is exempt if paid by a bank
or finance company in Malaysia or paid on loans granted or guaranteed by the government of
Malaysia. Single tier dividends are exempt from tax, while other dividends are taxed at 25%,
as is business income. All other income is taxes at a flat 10% rate. Tax on income taxed by a
foreign country may be reduced. Non-resident income and related taxation may be subject to
any number of tax treaties (Ibid).
Dividends paid, credited or distributed by cooperative societies to their members are
exempt from taxation. A co-operative society must be registered. Co-operative societies are
not exempt from taxation themselves. 2012 legislation exempts interest income on co-
operative society deposit balances of up to RM100,000. Moreover, there are limited
deductions and exemptions from taxation, in addition to the incentive noted below, as
follows:

15
A deduction up to a maximum of 25% of net income for contribution to statutory
reserve fund required to be created under the Cooperative Society Ordinance (Public
Ruling No. 9/2011 limits this deduction for additions to reserves to 25% of audited
net profits for the year).
An amount equal to 8% of the members' funds (Public Ruling No. 9/2011 limits this
amount to 8% of the member funds at the beginning of the year and further defines
what balances are included in the term member funds).
Tax exemption for a period of 5 years from the date of registration is allowed to
enable new cooperative societies to establish themselves during the initial stage of
establishment.
After the 5th years, cooperatives having members fund of RM750,000 or less will
continue to be tax exempted (Laws of Malaysia, Act 533).
Moreover, the primary incentive given to Takaful operators in Malaysia, is that of
exempting them from taxation for the years ending 2007 through 2016, for all income from
Takaful operations conducted in international currencies, provided the Takaful company or
unit is licensed under the Takaful Act of 1984. There is also an exemption from stamp duties
for co-operative societies for tax years beginning 2012 if the transaction being stamped is in
compliance with the Shairah. Finally, any company designated a Kuala Lumpur
International Finance Centre company, is exempt from taxation for a 10 year period and
exempt from stamp duties for loans done therein.
The Co-operative Society Act of 1993 (the Act), Part II, Section 4 defines a co-
operative society as:
A society which consists of individual persons only and which has as its object
the promotion of the economic interest of its members in accordance with co-
operative principles may be registered under this Act as a primary society.
(Laws of Malaysia, Act 502).
A society that consists of two or more primary societies only and whose purpose is
the facilitation of the purposes of the primary societies may be registered as a secondary
society. Similarly, a tertiary society is one that consists solely of two or more secondary
societies. A primary society must consist of at least 100 qualified individual members.
Exception for certain smaller co-operatives may be granted upon approval. The Act
specifically states that one of its purposes is to encourage and promote the establishment and
development of co-operative societies in all sectors of the economy and to help co-operative
societies increase their efficiency. Cooperative societies are specifically referenced in the
Takaful Act of 1984 as a mode of operation (Laws of Malaysia, Act 502).
According to the Malaysia Co-operative Societies Commission:
The cooperatives with financial and banking functions have pioneered the
development of cooperative movement since the 1920s. These cooperatives
conduct financial activities such as providing loans to members at reasonable
interest rates. Other activities under this function are Islamic mortgage (Ar-
Rahnu), investment and insurance services. The members comprise those with
regular salary income, especially in the public sector, statutory and private bodies.
Currently there are two specific cooperatives which are carrying out banking

16
functions, namely Bank Kerjasama Rakyat Malaysia Berhad and Bank Persatuan
Malaysia Berhad. www.skm.gov.my.
IV. REGULATORY OVERSIGHT & STANDARD SETTING
A. Legislative History
Malaysias Takaful Act 1984 is presently the worlds only specifically enacted
legislation governing the operation of Takaful funds. The laws governing Takaful vary from
one country to another. In other countries Takaful is subject to the existing laws applicable to
the insurance industry. Malaysias legislation recognizes Takaful as possessing unique
characteristics which justify an independent regulatory framework. One of the important
features of the Takaful Act 1984, which is not provided in conventional insurance, is the
requirement for the establishment of Shariah supervision.
In order to ensure compliance with Shariah principles, the Takaful operators are
required to observe the following at the company, as well as national, level:
The requirement to set up a Shariah supervisory board or Shariah committee within
the company, which advises the management to ensure that their activities fully
comply with Shariah principles.
At the national level, the National Shariah Advisory Council on Islamic Banking and
Takaful was set up at Bank Negara Malaysia (BNM) to advise on the Shariah aspects
of the operations as well as approval of various products and services.
The Takaful Act 1984 can be divided into four parts:
Part I: This provides for the interpretation, classification and references to Takaful
undertakings. Takaful is divided into two broad categories, namely General Takaful and
Family Takaful. Those who enter the plans are called Takaful participants, as opposed to
participants.
Part II: This provides the mode and conduct of Takaful undertakings, e.g. restriction
on the usage of the word Takaful, conditions of registration, restrictions on Takaful
operators, the establishment and maintenance of Takaful funds and allocation of surplus, the
establishment and maintenance of a Takaful guarantee scheme fund, requirements relating to
Takaful, and other miscellaneous requirements on the product of Takaful business.
Part III: This part specifies the powers vested in BNM and the appointment of its
Governor as the Director-General of Takaful in regulating Takaful undertakings, the powers
of investigation of BNM and provisions for the winding-up and transfer of business of a
Takaful operator.
Part IV: This provides for the administration and enforcement of matters such as
indemnity, submission of annual reports and statistical returns, offences and prosecution of
offences.
The Takaful Act 1984 was adapted from the Insurance Act 1963 and sections of that
Act were deemed non-Shariah complaint and were deleted; others were altered to comply
with Shariah requirements. The Insurance Act 1963 was subsequently repealed and replaced
with the Insurance Act 1996.
Under the Takaful Act 1984, a Takaful operator must be incorporated as a company as
defined in the Companies Act 1965 or as a society as registered under the Co-operative
Societies Act. The operator must have the required deposit and pay annual registration fees.

17
Moreover, it must maintain at all times surplus of assets over liabilities of not less than the
amount as may be prescribed from time to time. The Act requires that the objectives and
operations of the Takaful business must adhere to the tenets of the Shariah and must not mix
its operations with any prohibited activity under the Shariah.
B. Bank Negara Malaysia (BNM)
BNM, in order to spur the growth of Takaful, has forged certain guidelines. They
revolved around capital adequacy, financial reporting, anti-money laundering and prudential
limits and standards. It has elaborated and researched various issues which are faced by
Takaful companies and has issued guidelines to facilitate the operation of Takaful funds.
Some of these guidelines are:
Guidelines on Directorship for Takaful Operators
Guidelines on Prohibitions against unfair practices in Takaful Business
Guidelines on Claims Settlement Practices
Guidelines on proper advice for Family Takaful
Guidelines on Operating Costs of Family Takaful.

Source: Bank Negara Malaysias Shariah Governance Framework

18
Finally, BNM, in October 2010, implemented a Shariah Governance Framework
(SGF) that requires all Islamic financial institutions, including Takaful funds, to establish a
SGF. In addition to the Shariah advisory board requirement noted above, Takaful funds are
required to either employ internally, or to contract with external Shariah advisory firms that
will deliver a Shariah: (1) risk management control function; (2) review function; (3)
research function; and (4) audit function. Figure 1 illustrates the SGF.
Of particular note in the SGF is the critical role of the Shairah Audit and Review
functions. BNM defines a Shairah Audit as:
Shariah audit refers to the periodical assessment conducted from time to time, to
provide an independent assessment and objective assurance designed to add value
and improve the degree of compliance in relation to the IFIs business operations,
with the main objective of ensuring a sound and effective internal control system
for Shariah compliance. (BNM 2010).
The Accounting and Auditing Organization for Islamic Financial Institutions
(AAOIFI) defines the Shariah Review function as:
The primary objective of the internal Shariah review (carried out by independent
division or part of internal audit department) is to ensure that the management of
an IFI discharge their responsibilities in relation to the implementation of the
Shariah rules and principles as determined by the IFIs Shariah Supervisory
Board (SSB). (AAOIFI, Governance Standard for IFI No.3).
C. Islamic Financial Services Board (IFSB)
In 2006 the IFSB and IAIS wrote a paper titled Issues in Regulation and Supervision
of Takaful which deals with the application of the IAIS core principles needed to
accommodate Takaful such as corporate governance, financial and prudential regulations,
transparency, report and market conduct and supervisory review process.
In November 2009, the IFSB issued the Guiding Principles on Governance for
Takaful Undertakings. In December 2009, it issued IFSB-11, entitled Standard on
Solvency Requirements for Takaful Undertakings, which establishes solvency rules for
Takaful operators consistent with Solvency II (ISRA 2011). The main objective of this
standard is to emphasize capital adequacy and give confidence in the sustainability of the
Takaful market.
There are other relevant standards, such as: Guiding Principles on Conduct of
Business for Institutions offering Islamic Financial Services, Guiding Principles on
Shariah Governance Systems for Institutions Offering Islamic Financial Services, and a
Guidance Note on the Recognition of Ratings by External Credit Assessment Institutions on
Takaful and Retakaful Undertakings which buttress and underpin the growth of Takaful
throughout the world. Recently, the IFSB issued its Exposure Draft on Standard for Risk
Management for Takaful (Islamic Insurance) Undertakings (IFSB 2012).
D. Accounting Association of Islamic Financial Institutions (AAOIFI)
AAOIFI since its inception in 1991 has issued 81 standards, in which 4 standards are
related to Takaful (Shahul 2009). They are as follows:
1) FAS 12- General Presentation and Disclosure in the Financial Statements of Islamic
Insurance Companies. Basically, it deals with the following components:

19
Complete set of financial statements, including statement of participants surplus (or
deficit), and sources and uses of Zakah and charity funds;
General disclosures including those on earnings or expenditure prohibited by
Shariah; and
Treatment of changes in accounting policies, changes in accounting estimates etc.
2) FAS 13- Disclosure of Bases for Determining and Allocating Surplus or Deficit in
Islamic Insurance Companies. It has the following components:
General disclosures on contractual relationship between participants and insurance
operations manager;
Disclosure on accounting policies regarding the party that meets general and
administrative expenses; and
Disclosures on allocation of profit generated from investment of participants funds;
and on treatment of current deficit and/or cumulative deficit.
3) FAS 15- Provisions and Reserves in Islamic Insurance Companies. It contains:
Accounting rules for technical provisions such as unearned contributions provisions,
outstanding claims, and claims incurred but not reported;
Accounting rules for deficit reserves and equalization reserves; and
Recognition, measurement, and presentation of those provisions and reserves; and
disclosures on basis for determining provisions and reserves.
4) FAS 19- Contributions in Islamic Insurance Companies. It provides for:
Recognition, measurement, and presentation for contributions made on the basis of
donation by participants;
Disclosure on accounting policies for treatment of contributions;
Disclosure on accounting policies for withdrawal of policyholder and cancellation of
insurance policy; and
Presentation of Statement of Participants Revenue and Expenses.
Furthermore, all standards are reviewed. Review is to take into account, amongst
others, current market practices, prevailing conventional international standards, and
international best practices. And the review is to be carried out in consultation with the
industry experts.
E. Role of Shariah Boards & Committees
The general responsibilities of a Shariah Board or Committee are as follows:
Ensuring that both the shareholders and Takaful funds are handled and administered
in accordance with the Shariah tenets;
Catering expertise and guidance for the company in all matters pertaining to the
Shariah principles, its structure and investment process, and other operational and
administrative issues;
Consulting the authorities who may consult their Shariah Advisory Council where
there is any ambiguity regarding to investment, instrument, system, procedure and
process;
Scrutinising the companys compliance report as provided by the compliance officer,
transaction report provided by or duly approved by the trustee and any other report

20
deemed necessary for the purpose of ensuring that the investments are compatible
with the Shariah precepts;
Preparing a report to be included in the companys annual report certifying whether
the Takaful business has managed in accordance with the Shariah principles;
To make sure that the Takaful undertaking complies with any guideline, ruling or
decision issued by the authorities with regard to Shariah matters;
Vetting and advising on the promotional materials of the company; and
Assisting and attending to any ad-hoc meeting called by the authorities or any other
relevant authority (CIFP, op.cit.).
F. Fatawah
The first fatwa prohibiting conventional insurance in its modern form was rendered by
Ibn Abdeen, a Syrian scholar in 1834 (Khan 2008). As noted earlier, the modern prohibition
began in Saudi Arabia (1977), followed by fatawah in numerous Islamic countries, including
Malaysia (1982). Since then, there have been numerous fatawah or Shariah rulings on the
various practices surrounding Takaful (some of which are referred to as resolutions, when
issued by Shariah boards or committees). Resolutions do not carry the same legal strength as
fatawah, but for purposes of this paper, they are grouped under that heading for illustration
purposes only. Figure 2 list the primary sources of them.
Figure 2

19 wide ranging Resolutions pertaining to Takaful,


Bank Negara including Takaful Models, Takaful coverage for
Malaysias conventional Loans, Segregation of Takaful funds,
SAC distribution of surplus from the PSAs, provision of
reserves, etc.

Kuwait 15 Fatawah with respect to Takaful, including health &


Finance medical plans, auto insurance, protection against vandalism,
insurance of debt, insurance on cash balances, insurance on
House investments, etc.

OIC Fiqh Fatawah on health insurance, various aspect of insurance


Academy and use of reinsurance in the absence of retakaful operators.

Summary of Fatawah on Takaful and Retakaful summarized from www.isra.my

V. RISK ATTRIBUTES OF TAKAFUL


A. Risk Profile. Takaful, though socio-religious in its epistemology, is
nonetheless in the business of identifying, measuring & managing risks through avoidance
& transference techniques. Some risks are endemic to Takaful, e.g. the reputational risk
associated with Shariah compliance. Other risks are entity or firm level, e.g. those that might
be affected by the underwriting classes of a particular Takaful undertaking. Other risks are

21
systemic and affect the entire insurance industry. Some authors classify Takaful risks as
either pure or speculative. Pure risks, according to them, are those risks that have only 2
possible outcomes, i.e. loss or no loss and there is no possibly of gain. Speculative risks, they
aver, are those in which the uncertainty about the risky event could result in either gain or
loss (Obaidullah 2005).
Such taxonomies remind us that Takaful undertakings are inherently risky and that
risk of loss is ever imminent. Almighty Allah reminds us of the inevitability of (risk) by
identifying two forms of disaster (museebah):
And we shall surely test you with something ofloss of wealth and livesbut
give good tidings to the patient, who when disaster (museebah) strikes them, say,
indeed we belong to Allah, and indeed to Him we will return. (2:156-57).
Malaysia does have a better risk profile than other ASEAN nations when it comes to
natural disasters; being identified as high risk only in the area of floods (ASEAN 2011). And
at the moment anyway, Southeast Asia is less volatile politically than the Middle East and
North Africa (MENA) region. Yet, some risks simply are virtually unmanageable. In a world
marked by terrorism, ideological conflict, war, natural disasters, political unrest, ecological
disasters and technological errors, now, possibly more than ever before, the single most
dangerous risk is pure risk.
However daunting the task, Takaful, like its counterpart, insurance, must classify its
risks. The IFSB, which is based in Malaysia, is presently grappling with this very issue. As
noted earlier, the IFSB recently (November 2012) issued its Exposure Draft on Risk
Management for Takaful Undertakings. The taxonomy of Takaful risks is presented therein
as follows:
1. Reputational and Regulatory Risks associated with Shariah non-compliance,
caused by-
Breach of Shariah principles in its contracts
Differences in perceptions of Shariah compliance emanating from varying
interpretation of Fiqh Muamulat by Shariah scholars and differences in jurisdictional
practices worldwide
Increased competition and pressure to develop innovative products that are non-
compliant
Limited availability of Shariah-compliant investment instruments could lead to
questionable practices
Separation of participant funds (both risk and investment designated) and shareholder
funds in the mudharabah and yadd damman models and the concomitant agency risks
and vigilance in the areas of fairness and transparency
Inability to mitigate risks through diversification between stakeholder funds can result
in higher economic capital requirements
Qard mechanisms and risks associated with the requirement to make these loans to
participants, as well as the risk associated with their inability to repay them
Mis-segregation and mis-allocation of income and expenses between stakeholders
Misaligned underwriting costs and expenses resulting in the inability to meet the
requirements of the underlying contracts

22
Reinsurance and other risk transfer difficulties associated with excess exposure
concentrations or connected counterparties
Risks associated with the both the polemics over the legitimacy of using reinsurance
vis--vis retakaful, as well as the attribution of funds under both, e.g. the payment of
commissions as opposed to actual risk sharing arrangements
Credit risk exposure from retakaful contracts and the quality of risk selection and
pricing, requiring due diligence and good governance
2. Specific Risks of Particular Relevance to Takaful-
A. Operational risk or the risk of loss resulting from inadequate or failed internal
controls, people or systems; or from external events. It may also include the Shariah
risk of operators failing to meet their fiduciary duties. These risks may result in:
An inability to pursue opportunities, inefficiency and threaten business continuity
Breach of fiduciary duties
Underwriting management risk or failure to properly managed the contributions by
participants
Negligent, incompetent, fraudulent or criminal activities
Failure of information technology systems
Failure to be vigilant in monitoring outsourced activities, particularly as related to
Shariah norms and prohibitions
B. Underwriting risk is the risk of loss due to underwriting activities, including
assumptions used in pricing and assessment, later found to be incorrect, and may result in-
Failure to identify changes in expected and actual claims experience, including
mortality and morbidity, so as to acknowledge trends in claims and settlement costs
and needed changes in underwriting standards, policy provisions and pricing.
Faulty expense assumptions, including remuneration.
Increased lapses in policies and lack of persistency in renewals and new participant
contributions, all of which may affect risk pool volatility.
Monitor deficiencies or failures to collect on Qard, which may be linked to
perceptions of poor underwriting management; unlike conventional insurers, Takaful
funds can only repay these losses out of future surpluses and not new contributions.
Unacceptable concentration risk levels related from positive correlations between risk
pools underwritten and failure to transfer such risks to Retakaful plans.
Increased provisioning risk, which relates to level of reserves to meet future claims
and claims being processed.
Increased provisioning risk caused by failure to properly project losses by
underwriting and loss year and failure to reassess projection methods periodically.
Misperceptions created in the minds of participants as to minimum levels of returns
on Family investments or surplus distributions (participant reasonable expectations)
Mis-management of co-Takaful arrangements and under provisioning of related
claims.
C. Market risk is the risk of losses arising from movements in market prices, i.e.
fluctuations in values of leases, sukuk and other investments and deviation of actual returns
from expected returns. This risk may lead to-

23
Deficits in reserves and inadequate performance.
Failure to adopt investment strategies by investment instrument that quantify the
impact of fluctuations and are based on the ability to absorb fluctuations.
Failure to hedge in order to dampen such fluctuations by asset class.
Failure to align asset-liability management to create cross-subsidy between funds
being managed by one Takaful operation.
D. Credit risk is the risk that a counterparty fails to meet its obligations, resulting in
misalignment of operational, financing and investment activities, caused by-
Failure to provide for viable Retakaful relationships and to manage the provision of
coverage on General Takaful extended on a credit basis.
Failure to identify, measure and manage investment risks by asset class and fund
exposure.
Failure to manage Qard during growth periods or following major losses through
capital adequacy.
E. Liquidity risk is the risk of loss arising from an inability to meet impending
obligations or to fund increases in assets as they fall due without incurring unacceptable costs
or losses that may cause-
Inability to dispose of assets in an orderly manner, in time to cover claims or
withdrawals, or to pay debts in a timely manner; all of which may lead to the loss of
confidence, reputational damage, uncontrolled withdrawal, litigation or regulatory
action.
Inability to pay wakalah fees and to distribute surpluses.
Possible Qard drawdowns.
Inability to service debts related to PP&E acquisitions, fees for underwriting, etc.
Failure to implement, monitor and manage liquidity policies, including the failure to
plan for and have contingency plans to address shortages in internal and external
financing sources.
F. Legal and Compliance risk is related to the legal and regulatory implications of
operational activities, disputes and contractual difficulties, which may cause-
Unethical behavior, including poor handling of agency conflicts.
Failure to reconcile conflicting interests pursuant to IFSB-8.
Non-compliance with jurisdictional laws and regulations, which may be the result of
the failure to implement compliance review procedures.
Criminal activity, fraud and breach of international sanctions; all of which may
damage the reputational risk of the Takaful fund (IFSB Exposure Draft No. 14).
B. Risk Intermediation.
Underwriting is the traditional tool used in insurance risk intermediation. It is defined
by the International Insurance Institute as (e)xamining, accepting, or rejecting insurance
risks and classifying the ones that are accepted, in order to charge appropriate premiums for
them. Takaful operators adapt the underwriting process to determine contribution rate (in
lieu of premiums) using three stages:
Gathering Information;

24
Classifying risks, e.g. preferred, standard, rated, postponed or declined in life policies;
and
Determination of a contribution rate (Alhabshi op.cit).
The recent IFSB Exposure Draft-14 indicates that a risk management framework
(RMF) should be established, which is comprehensive in nature, contains a set of consistently
applied policies and strategies and encompasses the Takafuls appetite for risk, its processes
for managing them and the governance thereof. The policies typically address the issues of
risk retention, retakaful, Shariah-compliant hedging techniques and regulatory capital
adequacy requirements. Emphasis is given to the process of identifying as many foreseeable
risks as possible with an eye towards new and emerging risks. In addition to risk policies and
strategies, the RMF should contain a risk register, as well as risk identification processes and
risk assessment, response and control procedures.
The Exposure Draft further recommends an internal control framework covering the
key activities of the Takaful, encompassing risk detection and prevention controls of either a
manual or automated nature. Takaful undertakings are further advised to establish risk
monitoring information systems with comprehensive reporting capabilities. These controls
should be embedded in daily operations (1st line of defense), independent monitoring, the
review of the risk management mechanism (2nd line of defense) and an independent assurance
or audit function (3rd line of defense).
Finally, the RMF should have an asset-liability management (ALM) functionality,
which monitors assets and liabilities for mis-matches, divergence of actual and expected
levels of returns, misaligned risk-returns, liquidity requirements and embedded options in
contracts, e.g. settlement options, policy loan options, over-depositing options and surrender
or renewal privileges (all of which could result in additional costs). External factors and
changes in business composition and direction should also be considered (IFSB op cit).
Given Malaysias leadership in regulatory oversight in the Takaful and Islamic
Finance arenas, as well as its strong alliance with the IFSB, Malaysia is strategically
positioned to continue to play a leadership role in the global Takaful market. That said, what
will continue to be her greatest challenge will be to manage the risks inherent in Takaful,
while adhering to the social principles upon which Takaful is founded. One such challenge
will be to devise innovative ways to make Takaful affordable to the widest possible number
of her citizenry.
C. Retakaful
Takaful operators may transfer risks to larger operators. This is generically called
reinsurance, or retakaful in Islamic Finance. Reinsurance is defined as: Insurance bought by
insurers. A reinsurer assumes part of the risk and part of the premium originally taken by the
insurer, known as the primary company. Reinsurance effectively increases an insurer's capital
and therefore its capacity to sell more coverage. It also allows Takaful funds to shift or
transfer their larger risks to these companies, who accept these risks from a diversified list of
primary companies; thus, spreading the risk through their auspices, which could not
otherwise be intermediated by a single Takaful operator. The retakaful is global and some
of the largest reinsurers are based abroad. However, Malaysia is home to 2 of these large
retakaful operators subsidiaries, i.e. Munich Retakaful and Swiss Re.

25
Reinsurers have their own reinsurers, called retrocessionaires. Reinsurers dont pay
policyholder claims. Instead, they reimburse insurers for claims paid. They do so under 2
methods:
Facultative. A reinsurance policy that provides an insurer with coverage for specific
individual risks that are unusual or so large that they arent covered in the insurance
companys reinsurance treaties. Examples are coverage for jumbo jets or oil rigs.
Treaty reinsurance. A reinsurer agrees to assume a certain percentage of an entire classes
of business, e.g. as various kinds of general Takaful, up to preset limits.
Retakful operations are structured on the tabarru basis. They take contributions from
participating Takaful operators, who share in the risk pools. Retakaful operators primarily use
the wakalah and mudharabah models. The wakalah fee is usually paid up front and runs
approximately 5% for acting as wakil over the pooled fund. The mudharabah shares in the
profit from managing the investments of the pooled fund as the mudharib partner. The profit
percentage may vary but ARC, for example, charges 40%7.
Malaysian Takaful operators, on average, ceded about 20% of their commissions to
retakaful in 2011. That compares with roughly 34% in the GCC. The disparity is explained
by operators as being due to the GCC Takaful concentration in General Takaful vis--vis their
Malaysian counterparts (Ernst & Young 2012). Retakaful operators in Malaysia provide Qard
facilities to the Takaful participants in their funds.
There exists a shortage of retakaful operators worldwide; although it is less of
problem in Malaysia because of the presence of 4 retakaful operators. This has resulted in
some discussion over the permissibility of using reinsurance in lieu of retakful. This issue
was largely resolved when the OIC Fiqh Academy in its 1985 fatwah, stating: The Council
encourages Muslim countries to establish cooperative insurance and reinsurance institutions.
This is so that Islamic economics would be liberated from exploitations and violations of the
system that Allah has chosen for this ummah. Accordingly, absent an apparent weakness in a
retakaful or mutual or cooperative reinsurance company, e.g. failure to meet capital adequacy
requirements, etc., if there is a need to turn to the reinsurance market, the Takaful operator
should first try and obtain coverage from the retakaful, cooperative or mutual insurance
sector (Ismail 2009).
D. TIPS
Malaysia has a Takaful and insurance benefits protection system (TIPS) as a limited
protection system to cover both Takaful and insurance benefits. TIPS the acronym for
Perbadanan Insurans Deposit Malaysia (PIDM), an independent statutory body established
under the Malaysia Deposit Insurance Corporation Act 2011 (Act). Its stated purposes are to:
Administer a deposit insurance system and a Takaful and insurance benefits
protection system under the Act;
Provide insurance against the loss of part or all of deposits for which a deposit taking
member is liable and provide protection against the loss of part or all of Takaful or
insurance benefits for which an insurer member is liable;
Provide incentives for sound risk management in the financial system; and
Promote or contribute to the stability of the financial system.

7
http://www.acrretakaful.com/en/SEA/About-Us/Retakaful-Operational-Model/

26
PIDM collects premiums from member Takaful and insurance companies. The premium rates
are determined actuarially by the Malaysia Deposit Insurance Corporation (MDIC). TIPS
manages and segregates different funds into pools, as follows:
Family solidarity Takaful protection fund;
General Takaful protection fund;
Life insurance protection fund; and
General insurance protection fund.
There is no comingling of incomes or expenses between any of TIPS funds. There are limits
on the coverage provided by TIPS. The schedule of coverage benefits can be viewed at
http://www.pidm.gov.my/downloads/guide_TIPS_RCP.pdf.
VI FINANCIAL ATTRIBUTES OF TAKAFUL
A. Financial Intermediation
One of the common features Takaful shares with conventional insurance is the role it
plays in financial intermediation. Financial intermediation is a productive activity in which
an institutional unit incurs liabilities on its own account for the purpose of acquiring financial
assets by engaging in financial transactions on the market; the role of financial intermediaries
is to channel funds from lenders to borrowers by intermediating between them. (Retrieved
from http://esa.un.org/unsd/sna1993/introduction.asp).
While the above definition may be more suited for conventional insurance providers,
its application to Takaful, once modified, still applies; notwithstanding Takafuls motivation
of mutual protection and shared responsibility. (Engku Ali 2008). In short, modern financial
exigencies give Takaful little choice but to incur a liability (notwithstanding the charitable
donation character of participant contributions) on behalf of its participants, by collecting
contributions from them, and in turn, investing the net of those proceeds in a Shariah-
compliant manner in the marketplace in anticipation of fulfilling the future obligations to its
members. This is the essence of the economic activity known as the intermediation effect
(Smith 1978), or simply put, financial intermediation.
Insurance has been causally connected to economic growth in developed countries
and anecdotally believed to be an economic driver in others through job creation, risk
intermediation, etc. Studies have shown that it positively contributes to economic
development through financial intermediation in the financial market, particularly the long-
term investment market (Brainard 2008). That is attributable to the inherent need of insurance
carriers to match longer term obligations with longer term, relatively stable investments.
Data shows that through its investment intervention in the market, Takaful provides a
fairly steady source of liquidity. Put differently, Takaful is a source of funds, i.e.
contributions from its members or participants. Those funds quickly find their way into the
financial market after payment of concomitant expenses, e.g. commissions, overhead and
claims as they become due and payable. Those funds are invested with firms and government
as a significant source of liquidity. From the Takaful operators viewpoint, these investments
produce both income (from profits and dividends), capital gains from the sale of those
investments and other cash flows; all of which represent the cash inflows of the Takaful fund.
These aggregate funds inflows contribute to the overall well-being of the financial sector of
Malaysia and her economy.

27
The size of these inflows in Malaysia over the past nine (9) years, i.e. from 2003
through 2011 can be seen in Table 2. As can be seen from Table 2, Family Takaful net
contributions provide the lions share of the liquidity at 76.2% of contributions; while
Family inflows represent 60.9% of the total cash inflows from Takaful undertakings at
December 31, 2011. Net Family contributions grew 9.2% in 2011. Net contributions are net
of any brokerage commissions that might result in double counting. Net contributions are also
net of contributions paid for retakaful.
However, it should be apparent that General Takaful inflows have grown dramatically
over the 9 year period, i.e. a total of 413% or an average of 45.9% per year. Its contributions
have grown an average of 51.2% per year over the past 9 years. General contributions grew
12.4% in 2011. Obviously, both lines experienced slower growth in 2011. However,
preliminary numbers being reported for 2012 suggest growth may return to the higher levels.
Table 2
(In RM millions) 2003 2004 2005 2006 2007 2008 2009 2010 2011
Net Investment Income:
Family 165.3 156.6 192.3 232.0 284.5 298.8 354.8 447.3 501.3
General 21.5 14.7 19.6 32.3 44.6 50.6 57.7 68.4 84.5
Total Net Investment Income 186.8 171.3 211.9 264.3 329.1 349.4 412.5 515.7 585.8

Sale of Assets & Other Income:


Family 41.2 77.5 69.5 123.4 111.8 164.9 307.1 336.4 647.5
General 8.9 108.3 68.3 78.5 62.7 92.0 79.2 90.4 156.2
Total Other Income 50.1 185.8 137.8 201.9 174.5 256.9 386.3 426.8 803.7

Net Contributions:
Family 762.5 794.4 977.1 1,242.3 1,988.5 2,372.9 2,718.1 3,391.1 3,703.6
General 251.5 328.7 356.6 479.2 576.5 652.2 803.7 1,030.7 1,158.9
Total Net Contributions 1,014.0 1,123.1 1,333.7 1,721.5 2,565.0 3,025.1 3,521.8 4,421.8 4,862.5

General Reserves & Write- 326.0 375.4 558.8 662.3 849.7 1,032.3 1,167.2 1,394.4 1,717.2
Backs

Total Cash Inflow:


Family 969.0 1,028.5 1,238.9 1,597.7 2,384.8 2,836.6 3,380.0 4,174.8 4,852.4
General 607.9 827.1 1,003.3 1,252.3 1,533.5 1,827.1 2,107.8 2,583.9 3,116.8
Total Cash Inflows 1,576.9 1,855.6 2,242.2 2,850.0 3,918.3 4,663.7 5,487.8 6,758.7 7,969.2

Adapted from BNM 2011 Statistical Reports

Table 3 shows the asset holdings of Takaful in Malaysia from 2003 2011, along
with the respective percentage of those holdings. Family Takaful assets comprise 84.8% of
total Takaful assets in Malaysia. Almost 98% of Takafuls RM16.9 billion in assets at year
end 2011were invested in the Malaysian Islamic Capital Market, either directly or indirectly.
As can be seen from Figure 3, Takaful provides significant financial intermediation to the
Islamic Capital Market in Malaysia with 21% of its investment assets in Government Islamic
Paper (GII), 73.4% of those assets were in Shariah-compliant private debt and equity
instruments and 5.6% of its directly invested assets in other instruments. Although the BNM

28
reports do not disclose the debt or equity breakdown of Takaful fund capital market activity,
Ernst &Young 2012 World Takaful Report, sampled Malaysian Takaful operators, indicated
an allocation of 20% equity and 57% Sukuk; with 20% in depository accounts and roughly
3% in real estate. Those amounts approximate the amounts in Table 3. The corresponding
Malaysian debt/equity Islamic Capital Market investment would then approximate RM5.2
billion and RM1.83 billion, respectively.
Table 3
RM Millions and % Family General Total %

Fixed Asset 0.9 0.0 0.9 0.0%


Investment Properties 306.0 26.6 332.6 2.0%
Financing 42.3 0.9 43.2 0.3%
Gov't Islamic Paper (GII) 2,231.1 380.4 2,611.5 15.4%
Islamic Private Debt & Equities 7,935.2 1,196.9 9,132.1 53.9%
Other Investments 637.3 64.8 702.1 4.1%
Foreign Assets 8.6 0.0 8.6 0.1%
Investment Accts & Money Market 2,669.0 601.2 3,270.2 19.3%
Cash & Bank Balances 143.2 37.3 180.5 1.1%
Other Assets 404.6 261.8 666.4 3.9%
Total Investment 14,378.2 2,569.9 16,948.1 100.0%
Adapted from BNM 2011 Statistical Reports
As noted earlier in this paper, Malaysia has 8 Takaful operators. The majority (6) have
affiliation with banks or international financial firms. The 2 original Takaful funds are the
exceptions, i.e. Ikhlas and Takaful Malaysia. All Takaful operators have investment linked
funds; generally growth, income, fixed or balanced. The actual investment mix for Takaful
funds varies. Review of Takaful financial statements reveal investment mixes approximating
the breakdown between government Islamic securities, private Islamic debt and equities and
depository accounts discussed herein above. All Takaful and Retakaful operators in Malaysia
are required to have a investment policies that reflect the reasonable expectations of their
participants pursuant to BNM Guidelines on Investment Management for Takaful
Operators.
Figure 3

Takaful Investment Asset Allocation


In Millions RM

702.1
2,611.5

Gov't Islamic Paper


(GII)
9,132.1 Islamic Private Debt &
Equities
Other Investments

December 2011

Adapted from BNM 2011 Annual Report

It is noteworthy to mention that Government Islamic Paper or GII is a controversial


Islamic security. They are trust certificates issued on the basis of bai al-inah, a method of
Islamic finance that is controversial, as it involves selling a financial product or other item to

29
a party for cash and buying it back at a higher price over time or immediately (a clear case of
riba absent an exemption). It is rejected by the Maliki and Hanbali mudhahib. It is deemed
permissible in the Shafiee madhab only; although it is permissible under the Hanafi madhab
if it involves a third party.
Thus, its acceptance, as practiced in Malaysia is a minority position. Imam Shafiee
preferred an unwillingness to read into the intention of the parties. In other words, he did not
look past the 4 corners of the operative agreement. Thus, whether or not the parties intended
at the point of the first part of the sale to resell the item back to the counter-party at a higher
price would not be investigated under the Shafiee approach. That does not seem to be likely
in the GII transaction, as it is clear that when the paper is issued, it is intended to be
repurchased by the government (although it is possible that the holder of the certificate might
seek to transfer it; thus meeting the Hanafi stipulation of it being acceptable if repurchased by
a third party). However, even in the case of the third party transfer, the rules governing the
tradability of debt must be observed.
Malaysias SAC, by Resolution, decided to accept the minority position as it is vital to
the needs of BNM to be able to access the liquidity market. Failure to do so would clearly
create a hardship for BNM and in turn the people of Malaysia. Also, when faced with the
choice, it is a legal maxim to choose the lesser of the two in harm. Thus, it is either bai inah
or conventional money market operations; bai inah being the clear choice in such a case.
Moreover, scholars in Malaysia have called into question the strength of the Hadith collected
by Abu Dawud, wherein he transmits: If you sell to one another with inah, hold the tails of
cows (meaning then just go for the worldly gains and ignore your religion) (Al-Fawzaan
2005). That said, however, when there is no commodity involved, the exchange in bai al-
inah is purely monetary, subjecting it to the rules of bai as-sarf or spot transactions (money
being analogized by many scholars to gold or silver). (Ayub 2007).
Table 4
Return on Investments
RM Millions
2003 2004 2005 2006 2007 2008 2009 2010 2011

GII 426.7 597.4 662.2 732.6 778.0 855.8 1,296.1 2,255.7 2,611.5

Islamic 2,047.7 2,463.9 2,997.7 3,191.3 3,871.3 4,844.7 6,181.6 7,605.1 9,132.1
Debt/Equities
Other 9.9 5.3 59.2 63.7 305.3 394.0 543.5 678.1 702.1

Total 2,484.3 3,066.6 3,719.1 3,987.6 4,954.6 6,094.5 8,021.2 10,538.9 12,445.7
Investments
Returns 186.8 171.3 211.9 264.3 329.1 349.4 412.5 515.7 585.8

ROI-HPR 7.52% 6.17% 6.25% 6.86% 7.36% 6.32% 5.84% 5.56% 5.10%

Source: Adapted from BNM Annual Reports

Table 4 shows the annual returns on investments of Takaful funds in Malaysia. The
2011 return of all Takaful funds in Malaysia (5.1%) is slightly lower than the returns shown
in the E&Y sample for the same period, i.e. 6%. That same sample shows returns for 2007
through 2010 at 3%, 4%, 3% and 4% for those years respectively. As can be seen, the returns
for the same periods above show 7.36%, 6.32%, 5.84% and 5.56% respectively for the years
2007, 2008, 2009 and 2010. However, the sample in the 2011 sample, for example, only
30
included 3 Takaful respondents, while Malaysia had 8 Takaful operators in 2011. The
difference might be attributable to method of calculation. In Table 4, except for 2003, the
average investment (the current year plus the prior year divided by 2) is used as the
denominator in the calculation. In any event, geometric mean return over the 9 year period in
Table 4 is 6.29%, indicating that Malaysian returns are higher on average than those in the
GCC, which were 13%, -2%, -4%, 5% and 6% for the period 2007 through 2011 according to
the E&Y sample.
It is remarkable that in 2011, for example, conventional insurance returns on
investments were 12% based on the E&Y sample. If the results are representative of the
difference between the returns for conventional insurance vis--vis Takaful, this disparity
does not bode well for Takaful participants and operators. It is indicative of poorer
investment performance and will undoubtedly, if conventional wisdom serves well, impede
the growth and penetration of Takaful in the future.
B. Capital Structure
Cost structure. Table 5 is an approximation of the cost structure of Takaful in
Malaysia. An approximation is used since BNM reports do not breakout in detail certain
costs and do not include accrued unpaid benefits or claims in their outflow reports.
Nevertheless, the tabulated amounts give the reader an idea of the costs as a percentage of net
contributions, which appear comparable when using the E&Y 2011 Malaysian sample
amounts as benchmarks.
Table 5
Core Operating Costs & Ratio for Takaful
RM Millions

Source: Adapted from BNM Annual Takaful Reports

The comparable E&Y Malaysian sample amount for core operating ratio shows that
operating costs are 78% of contributions for 2011 for the sampled Malaysian Takaful
operators, while the above ratio is 75.9%. GCC core operating costs, by contrast, were 102%
of contributions, while conventional insurance companies in Malaysia had core operating
costs of 87% of their premium base. These amounts and ratios indicate that Malaysian
Takaful operations are likely more efficient. The 2011 data suggests that Malaysian Takaful
funds operate with an approximate operating margin of 24%.

31
Similarly, the comparable E&Y Malaysian sample shows a commission payment ratio
for the sampled Malaysian Takaful operators at 13% for 2011. The above ratio, though not
displayed for 2011, is approximately 15.6%, slightly higher. This could be due to method of
calculation, i.e. net versus gross contributions, as the ratio on the above numbers would be
13.5% if based on gross contributions (i.e. net contributions plus commissions), a total of
RM5,622.2. In any event, Malaysian conventional insurance commission payment ratio
shown in the E&Y report for 2011 is 14% or slightly higher. However, GCC Takaful
commission payment ratio is 4%, while the ratio in Saudi Arabia is 6%. According to the
E&Y report, these differences are perennial, though GCC ratios may increase as competition
stiffens there.
Finally, Table 5 shows that claims and benefits paid constitute roughly 45% of
Malaysian Takaful net contributions. This is in line with the E&Y report, though it shows the
ratios separately for Family (approximately 45%) and General (approximately 59%). Once
weighting and sample size are considered, the above ratio appears comparable and is likely
reasonable. Malaysian claims and benefits payment ratios have been perennially lower than
the GCCs. Bahrains ratios are dropping and approaching those of Malaysia. No comparable
data was shown for Malaysian conventional insurance companies (although BNM reports
may carry the requisite amounts).
Cost of capital measures. Most Malaysian Takaful operators have bifurcated capital
structures, i.e. they use the Mudharabah or Hybrid models. Insurance firms use cost of capital
as a benchmark for premium charges, capital allocation and performance measurement
(Exley 2006). Traditional cost of capital models, e.g. CAPM and the modifications of
Modigliani and Miller, may not adequately depict cost of capital for insurance firms (where
the participants/participants are providers of capital). In Takaful undertakings, the expected
return of the participants is an important consideration; not just because of the investment
aspects of Family funds, but because the participants are real stakeholders in the fund.
Merton and Perold, in their seminal work, were among the first to identify insurance
companies as principal financial firms (Merton & Perold 1993). A principal financial firm
is one that acts as principal in the ordinary course of business. In the case of insurance, the
firm is liability-related, i.e. the underwriting of guarantees. Principal financial firms have 3
distinguishing features: (1) their customers (as opposed to investors) are credit sensitive;
(2) their opaqueness (reluctance to disclose details of their financials) causes them to have a
higher cost of risk capital; and (3) they have a high sensitivity of profitability to the cost of
risk capital (ibid).
Merton and Perold defined risk capital as the smallest amount that can be
invested to insure the value of the firms net assets against a loss in value relative to the risk-
free investment of those net assets. They defined net assets as gross assets minus
customer liabilities (valued as if these liabilities are default-free). The importance of Merton
and Perolds analysis is that it brought attention to the fact that the cost of capital for
principal financial firms is complicated by the difficulty in assigning such a cost to customer
liabilities (Exley 2006). Little research appears to have been done for Takaful in the area.
Nevertheless, insurance companies still calculate cost of capital, risk capital and firm
valuation using the following methods:

32
WACC or weighted average cost of capital (weighting debt as one of two risky assets
based upon expected rates), and deriving the equity portion of the computation using
the CAPM model (which requires knowledge of the firms beta, in addition to the
market rate of return and risk free rate of return). Aviva has been known to use this
method.
Comparisons of returns to selected hurdle rates, e.g. RORAC. RORAC is calculated
by dividing the risk-weighted return by the economic capital. Risk-weighted return is
based on operating results, but credit risk adjustments are replaced by expected losses.
Economic capital is defined as Merton and Perold defined risk capital.
Market Consistent Embedded Valuation (MCEV), which is a bottom up approach to
embedded value calculations; essentially the risk capital noted above. This approach
uses present value calculations, but applies separate discount rates for each cash flow
based upon the risk appropriate for the asset/liability being valued. Among the
liabilities, of course, are those relating to claims and benefits. It also adjusts
valuations with so-called frictional costs, some of which were identified in Merton
and Perolds paper, e.g. agency costs, moral hazards, information costs, taxes, costs of
raising money, etc. Munich Re favors this method.
C. Growth Patterns
The development of a financial system is referred to in the literature as financial
deepening. Financial deepening and economic development are closely correlated
(Kiyotaki 2012). The financial sector in a society is by its very nature a subset of the culture
or society that gave genesis to it. A nations financial sector is not insulated from the
influences, history, axioms and culture of that nation. Culture influences the norms and
collective values of a society. These are axiomatic and empirical research substantiates them.
Seminal research by Hofstede (1984), Schwartz (1992) and Gray (1998) are instructive.
Malaysias financial system is influenced by its norms and values. An Islamic
financial system must be imbued with Islamic norms and values. That is not to say that
remnants of colonial and imperial domination do not exert tremendous magnetic pull on a
nascent Islamic financial system (Hasan 2010). Yet, there is, as stated in the Islamic Financial
Services Industry Developments Ten-Year Framework and Strategies, a distinct need for
a socially inclusive financial system.
Among Asian nations, Malaysian culture is relatively rich in diversity, i.e. it is
comprised of several religious and racial groups. Takaful is indigenous to the Islamic ethos,
which is remarkable in Malaysia. And though it has been in this milieu that Takafuls nascent
beginnings have taken root, from a domestic standpoint, this may also restrict that growth.
Though the growth so far has been steady, it may require that it extend its reach to the
broader society and global village, in order to maximize that growth.
Malaysia is no neophyte in integrating her Islamic products into the larger financial
system. She has been successful in integrating her Islamic banking system into the larger
conventional banking sector. She is now faced with the similar, yet distinguishable, task of
doing the same with Takaful. Banking and insurance are both financial products, but their
constituencies and drivers are not necessarily the same; even similar. The decision to invest
in insurance, after all, is a quintessential risk aversion decision; albeit all financial
intermediation is at some level risk avoidance, transference or management (Allen 1996).

33
Figure 4 shows the wide disparity in Malaysia between Takaful contributions and
conventional insurance premiums. Takaful is roughly 10% of the total insurance business.
The data does not appear to indicate any significant penetration overall. However, more
precise empirical testing would be needed to draw statistically relevant conclusions.
Nevertheless, Figure 4 does, at least, show that there is plenty of room for growth
domestically for Takaful, if the financial and marketing challenges can be met. For example,
Figure 4
Total Malaysian Premiums
2003-2009
In Millions RM
Compiled from BNM Reports & Intl Ins. Inst. Fact Books
50,000.0

45,000.0

40,000.0

35,000.0

30,000.0

25,000.0

20,000.0

15,000.0

10,000.0

5,000.0
Total Malaysian Takaful Premiums
0.0
Total Malaysian Premiums 1 2 3 4 5 6 7 8 9
Total Malaysian Takaful Premiums 1,014. 1,123. 1,333. 1,721. 2,565. 3,025. 3,521. 4,421. 4,862.
Total Malaysian Premiums 21,314 24,521 27,462 27,660 30,531 31,085 31,374 37,925 43,244

Family Takaful should be closely correlated with demographics. Malaysias Muslim


population was 60.4% of its population (according to the 2000 census)8. That statistic would
appear to support a significant opportunity for growth among the Muslim population alone.
Moreover, if Takaful grows keeping both its technical and socio-religious purposes in mind,
Takaful, as Islamic Finance, can prove to become a significant proponent of dawah, i.e.
spreading Islam and thus opening inroads into the insurance needs of the larger population.
Figure 5

8
http://www.indexmundi.com/malaysia/demographics_profile.html

34
Adapted from Bank Negara Malaysia-2011 Statistical Report

Figure 5 depicts the growth trends in Family and General Takaful net contributions in
aggregate over the same 9 year period. Malaysias Family Takaful growth has been
impressive thus far. Net Family contributions have grown 385.7% from 2003 to 2011 or an
average 42.9% per year before adjustment for inflation. General Takaful grew 360.8% over
the same period; or an average 40.1% per year before adjustment for inflation. However,
growth has slowed. Family funds grew at an unadjusted 9.2% from 2010 to 2011; while
General funds grew at an unadjusted 12.4%.
The determinants for growth of Family and General Takaful are different. Though
there is the need for further research and testing in the area, recent studies have shown that in
addition to population growth, the following are some of the more significant determinants of
Family Takaful demand: income, employment rates, interest rates, financial development
(deepening as noted herein above), pensions, price, equity investment, education,
urbanization, age and household size. There appears to be a negative correlation with savings,
as it likely represents an alternate use of funds vis--vis Takaful; as well as inflation, which
tends to erode and contract demand for coverage (Yazid et al 2012). Some studies in the area
of conventional insurance draw correlation between life insurance and a nations GDP (Feyen
et al. 2011) and per capita income (Enz 2000). In any event, it would seem that properly
conducted empirical studies on Malaysian Takaful might lead to more precise insight into
growth prospects.
The determinants of growth for General Takaful are much different. They vary by the
area of risks or classification. For example, vehicle Takaful is directly correlated with the
number of vehicle drivers. Financial Takaful might be correlated with market activity, e.g. the
volume of sukuk issuances. Commercial based General Takaful might be correlated with the
number of firms in a nation (Michael-Kerjan et al 2009), their size, leverage, tax profile,
expected bankruptcy costs and managerial ownership (Hamid et al 2009). Or there may be
correlation with asset exposure risks. Shipping or trade related General Takaful might be
correlated with import and export activity. There is also evidence that suggests that non-life

35
insurance is correlated with cultural norms of power distancing, individualism and
uncertainty avoidance (Treerattanapun 2011).
Finally, BNM publishes annual statistic on new Takaful certificates and certificates in
force. For example, for calendar year 2011, there were approximately 940,800 new Family
Takaful certificates issued. This represents a fairly significant growth statistic given the size
of Malaysia. However, there were also 464,400 or so terminations during the same period.
This may indicate poor service, dissatisfaction, or plain ole hard economic times. There were
approximately 3,251,600 certificates in force at calendar year end; or again, roughly a ratio of
11% (roughly the same percentage shown in Figure 4, i.e. Takaful contributions to
conventional insurance premiums) when divided by the total Malaysia population. Economic
analyses of these numbers and possibly empirical studies may shed important light on the
issue of penetration in the domestic Family Takaful market. In order to develop the
innovative Takaful products needed to penetrate the General Takaful market and to benefit
from it growth, more industry and panel research may be needed.
As noted, Malaysia is a world leader in Takaful with approximately 20% of the
worldwide market. That is so even though Saudi Arabia is stated to garner about 67% of the
worlds Takaful market. However, Saudi Arabia has, since 2004, essentially required all
Takaful operators to use the cooperative insurance model. The cooperative model is not
pure Takaful and may not even be Takaful at all. It does not segregate participant funds, does
not require investment in Shariah-complaint instruments and is not required to have
Shariah advisory committees or boards. Moreover, Malaysia is positioned next to several
large potential markets mentioned in the E&Y report, i.e. Indonesia, Pakistan and India.
Other potential markets mentioned as possible targets are also within short reach of Malaysia,
i.e. China, Bangladesh and Turkey. And then theres MENA, i.e. Middle East and North
Africa (E&Y op cit). All of these markets are within the reach of Malaysian Takaful.
Hence, the questions noted in the Abstract are particularly relevant. Will Malaysian Takaful
be able to compete in terms of performance, risk management and innovation? As it grows,
will it jettison its Shariah norms and prohibitions, as Saudi Arabia has apparently done; or
will Malaysia stay the course of being the worlds stalwart of Takaful and grow in a Shariah-
compliant and sustainable manner?

VII. Conclusion & Findings.


Our analytic review leads us to believe:
Malaysia is positioned well, both regionally and globally; but should expect stiff
competition from both the GCC and Indonesia
Malaysias strong global position is buttressed by its burgeoning Islamic Financial
system, robust regulatory oversight and involvement in development initiatives, and
the sheer force of will of the Malaysian people to establish the Shairah in their
financial lives.
General Takaful is set for a major boost over the forthcoming years, with the
emergence of new players to enhance the competitiveness of the industry and buoyed
by the continuing increase in public awareness of the Islamic financial products.

36
The rapid pace of development of retakaful business will reinforce and enable further
expansion of General Takaful business, particularly in the commercial lines.
The sound and conducive regulatory, supervisory and Shariah framework of Malaysia
that governs Takaful and Islamic Finance will continue to support sustainable growth
of Takaful; particularly General Takaful.
Need to build a critical mass of human capital needed to service the growth
anticipated in Takaful, including the need to monitor the Shariah risk associated with
only a few scholars and some sitting on numerous boards or committees
There is a need for greater harmonization of accounting practices & less opaqueness
in financial disclosures by Takaful operators.
Moving forward, product innovation will continue to be a key ingredient in attaining a
competitive growth.
The worldwide Muslim population is now estimated to be 1.6 billion. Family Takaful
has a positive correlation with population.
Takaful in Malaysia is only 11% of the overall risk intermediation market. There is a
significant opportunity for penetration that still exists domestically.
Takaful is a intermediate contract that can support other Islamic Finance transactional
contracts, e.g. in sukuk, REIT, etc. Thus, growth in worldwide Islamic Finance should
increase General Takafuls base of business.
Innovative approaches to marketing, e.g. bancatakaful, as well as product
development (especially investment-linked and wealth management products) can
spur growth in contributions.
Offering tax incentives or tax favored treatment to Takaful contributions, investments
and income can trigger growth as it has elsewhere, e.g. the US (where insurance
products are given tax favored status). For example, limiting taxation of Takaful
surpluses to zakat might be considered or making contributions to certain classes of
Takaful, tax deductible, in whole or part.
Building smart partnerships and global alliances will allow Malaysian Takaful
operators to penetrate lucrative markets, e.g. the GCC and grow through cross-border
cooperation, e.g. in the new market potential of North Africa.
Marketing Takaful generically as ethical, socially responsible, even as a mutual
insurance scheme, can help penetrate Malaysias non-Muslim population and Western
countries.
Innovative Shariah based approaches to dealing with the problems already faced in
the West will be needed, e.g. rejecting applicants with pre-existing conditions
outside of the risk appetite of operators or red-lining risky areas or population
Takaful operators will have to be vigilant in guarding the epistemological foundation
that Takaful is built upon and not succumb to the temptations of placing too much
priority on profit, lest Takaful begin to mimic conventional insurance.
Takaful funds and operators should consider, and the regulator should assist,
expansion into new market segments through merger and acquisition possibilities,
where they exist.

37
Affordable Takaful plans, possibly subsidized by the government, should be
developed for the poor or other classes of the population; possibly linking them with
other micro-finance projects.
Takaful schemes might be linked with various pension and retirement schemes to
further penetrate the domestic and foreign markets.

38
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