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Short Essay

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This project paper is a partial fulfilment of Module TK2002 of Part II of Chartered Islamic Finance Professional (CIFP) INCEIF

September 2010

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Takaful organisations are an integral part of a successful Islamic economy and social security system. Discuss the contributions that can be made by the industry towards this end.

Table of Contents 1.0 2.0 3.0 4.0 Takafuls Position within the Islamic economy Takafuls Contribution to the Islamic economy Challenges Conclusion

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1.0

Takafuls Position within the Islamic economy

The Islamic economic system is based on four principles as follows: All wealth belongs to Allah. "And give them of the wealth of Allah which He has given you." [An-Nur: 33] The community is the trustee of the wealth: "Believe in Allah and His Messenger, and spend whereof He has made you heirs."[Al-Hadid: 7] Hoarding of wealth is prohibited "And those who hoard up gold and silver and spend not in the way of Allah; announce to them a painful chastisement." [At-Tauba: 34] Circulation of wealth is a duty "Whatsoever Allah may restore unto His Messenger - is due unto Allah and unto His Messenger - the orphans and the needy ...so that it may not be confined to the rich amongst you." [Al-Hashr:7] Therefore, as well summarised by Omar1, the components, relationship and goals of the economic system must be based on sources of Islam. An Islamic economic system does not necessarily concerned with the amount of financial income and expenditure, imports and exports, and other monetary statistics. While such matters are no doubt important, Islam is more concerned with the spirit of the economic system. Islamic finance differs from conventional finance in terms of its belief on business practices which must all be based on Islamic principles. The Islamic financial system invests the suplus money from households, individuals, corporation and the government into Shariah-compliant products as depicted in the chart below. Islamic banks, takaful companies, Islamic investment banks as well as Islamic private equities companies act as an intermediary to channel those surplus money into the financial market system. Proceeds from the Shariah compliant investments would be shared with households, individuals, corporation and the government under a predetermined agreement. Key to this arrangement is the prohibition of riba, exclusion of investment into non-permissible sectors and business entities as well as a transparent transaction (in terms of pricing, duration, delivery and
1 Omar, Mohd Azmi. The Islamic Economic System: Overview. International Islamic University Malaysia. Malaysia. Page 3 of 16

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parties involved). The Islamic Financial System

Source: INCEIF

Surpl (Hou Corp Gover

Takaful is an important element of the Islamic financial system and the economy. It creates synergy and provides a conducive environment for the Islamic financial system to be an efficient mobiliser of resources and provider of financing for productive economic activity. Its position within the Islamic financial system enhances the resilience and robustness of the Islamic financial system to withstand financial shocks and contributes to increasing the overall stability of the Islamic financial system.

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The chart below shows the interdependency of takaful with the banking and capital market industry. For the Islamic banking industry, takaful operators provide Shariah-compliant protection and coverage for the various Islamic banking products. In addition, banks and takaful operators also enter unto bancatakaful arrangement to penetrate into markets not covered by traditional agency entities. In the capital market, takaful operators participates activity in subscribing to Islamic financial instruments such as sukuk, Islamic equities and money market. The wide range of Islamic financial instruments provides the opportunity for takaful operators to invest their funds into the capital markets to generate attractive returns to its shareholders. Interdependency of Market Players

Source: BNM Despite the important role that takaful plays in the Islamic financial system, its market share in terms of total assets of Shariah-compliant assets is significantly low. KFH Research Ltd2 estimates that the takaful sector only made up 0.4% of total assets of Shariah-compliant assets in 2009
2 KFH Research Ltd estimates that total Shariah-compliant assets stood at USD964.2 billion in 2009

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compared to Islamic banking at 79.9%, sukuk (11.5%) and Islamic equity funds (4.7%). Breakdown of Shariah-Compliant Assets (2009E)

Source: KFH Research Ltd

Ernst & Young in its World Takaful Report 2010 reported that total global takaful contributions increased from USD1.4 billion in 2004 to USD5.3 billion, translating to a CAGR (2005-2008) of 39%. Total takaful market is expected to reach USD8.9 billion in 2010. In 2008, the strongest growth in Takaful market came from Indian sub-continent at 37% followed by the Gulf Cooperation Council (GCC) at 31% and South East Asia and Levant at 27% respectively.

Isl eq fund

Since takaful does not operate in a vacuum, it is not isolated from the challenges faced by the financial system. KFH Research Ltd identified two indirect impacts on the takaful operators following the subprime crisis in 2008. The impacts are as follows: Lower returns from takaful operators. During 4Q08, major takaful operators witnessed a decline in their returns on equity which negatively impacted the policyholders fund and cause takaful operators to lose additional income. The GCC experienced a sharper decline as compared to Malaysia as its takaful operators in Malaysia hold a lot more of liquid assets such as equities and sukuk, which were easily sold during a market downturn.

Return on Equities Comparison between GCC and Malaysia (2005 2009)

Sukuk, 11.5%

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12.0%
Source: Ernst & Young Business strategy and direction. The recession and slowing down of economy has adversely affected takaful companies in terms of strategic, operational, compliance and financial risks. However, the impact is expected to be limited as takaful companies are mainly based in Southeast Asia and GCC countries, which are expected to continue to chart commendable economic growth on the back of strong economic fundamentals, high oil revenue and large investment in infrastructure projects.

8.0% 4.0% 0.0%

2.0 Takafuls Contribution to the Islamic economy

Takaful plays a crucial role in managing and mitigating the risks in Islamic finance. Takaful operators assume the role as economic or financial intermediaries as they mobilise long term funds in the form of policy holder contributions and invest them in the Shariah-compliant investments. As custodians of takaful policy holders funds, these operators have an obligation to ensure that not only are the takaful funds managed and invested on sound basis and in accordance with Shariah rules and principles, but are also managed with the standards of their counterparts in the industry. 2.1 Security System

Takaful plans provide cover in the form of mutual financial aid from payment of takaful benefits to

the policy-holder or heir. As a Muslim, while we must accept the terms and surrender to qada' and
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200

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qadar, it does not mean that we have to remain idle and quiet without taking ways to prevent or minimise obstacles or accidents from happening or reduce the risks that would happen. These risks must be managed wisely so that their impact can be reduced and leaves no significant impact on the persons mind and body, as well as for his next of kin in the case of death. For individuals, family takaful products, which includes education takaful, investment-linked takaful and medical takaful would fit the purpose. Family takaful is also relevant for corporates as it offers some kind of a security to its employees. General takaful products also fit this role. The table below illustrates the various takaful products offered by Syarikat Takaful Malaysia Berhad and the security or coverage attached to it. Syarikat Takaful Malaysia Berhad: Selected Products Takaful Product Security Element Corporates and Organisations Cover against loss of or damage to the subject matter due to theft whilst Burglary Takaful contained in the business or trade premises. Also cover the damage to Scheme your premises due to forcible entry or exit accompanied the event of theft. Foreign workers will be financially compensated in the events of accident resulting in death or bodily injury. In addition, the plan also provides coverage for Repatriation Expenses and Personal Accidents outside working hours. With this plan, financier such as banks, cooperative loan society or finance company would be able to protect its financial interest on credit facility granted to its client in the event of non-repayment due to sudden death or permanent total disability of the client. To protect the company from suffering financial loss arising from any invariably to entrusted money, securities, goods etc to the employee or delegate monetary responsibility to the employee. This plan covers for private dwelling, i.e. defined as walls constructed of wholly bricks or partly wood or wholly wood. Scope of cover for private dwelling are as follows :

Foreign Worker Compensation Takaful Scheme

Group Family Takaful Plan (Credit Facility)

Fidelity Guarantee Takaful Scheme Personal Baitul Sa'adah Takaful Scheme

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Loss or damage to private dwellings. Loss or damage to household contents of private dwellings. Death or Permanent Disablement compensation to the Participant. Funeral Expenses. Third party liability. Cover the lost and damage due to fire, lightning or domestic gas explosion. Cover the lost and damage due to accidents. Covers the requirement under a contract which normally specifies the need to have adequate cover or protection for building under construction. Cover for electronic/ computer related equipment including the operating systems software. Covering the good during delivery, which may involves risks of the following: Marine Cargo Takaful Scheme Fire or explosion Stranded, grounded sunk or capsized of vessel Overturning or derailment of land conveyance Collision of vessel Natural disasters The plan covers : Damage to the boiler or other apparatus described in the schedule Boilers & Pressure Vessel Takaful Scheme of the Certificate. Damage to surrounding property belonging to Participant e,g, buildings, machinery, stocks etc. Participants liability on account of fatal or non-fatal injuries to, or bodily injury and damage to the property of third party. Source: Syarikat Takaful Malaysia Berhad3 Takaful also offers more alternatives to the Muslims to save their money in a safe and more systematic manner. As such, takaful can encourage the practise of regular savings for a fixed period with a view to creating a kind of retirement or long term contingency fund. Therefore, the takaful
3 http://www.takaful-malaysia.com.my/general/products/Pages/corporate.aspx Page 9 of 16

Fire Takaful Scheme Motor Takaful Scheme Engineering Contractor's All Risks Takaful Scheme Electronic Equipment Takaful Scheme

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operator plays the role as savings institution and a custodian of money deposited in its custody to serve the future interest of the Muslim community. The takaful operator would then use the savings of the contributors in Shariah-compliant investments. This gives an opportunity for contributors to indirectly invest the money in accordance with Islamic principles. 2.2 Capital Market Takaful is based on the concept of social solidarity, cooperation and mutual indemnification of losses of members. It is a pact among a group of persons who agree to jointly indemnify the loss or damage that may be inflicted upon any of them, out of the fund they donate collectively. Therefore, the major earnings contributor for takaful operators should come from underwriting income. While Malaysias takaful operators has consistently derived its profits from underwriting income, the trend has just started in GCC4. The author believes this is due to impact of the subprime crisis that started in the final quarter of 2007 and into 2008, which had reduced the value of investments in GCC especially after real estate prices slumped drastically. In addition, the takaful operators had reconsider their strategy and return to their core business of underwriting risks instead of investment and speculation. Net Income Breakdown of Takaful Operators in GCC and Malaysia (2007-2008) GCC Malaysia

Source: Ernst & Young

The emergence of takaful operators has helped to keep the Islamic financial system vibrant as takaful operators invest the savings/ funds into Shariah-compliant businesses and asset class with the aim to increase returns to shareholders. This includes investment into real estate, Islamic
4 As reported by Ernst & Young in its The World Takaful Report 2010 Page 10 of 16

20%

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equities, sukuk, and money market. The returns would then be channelled back to the financial market through dividend payment and profit distribution. The higher returns would also translates to higher profitability and leads to more zakat payment, which would be channelled to the society. Movement of Funds

Ta div
Source: Author The availability of surplus funds from takaful operators has also led to the development of other segments within the capital market such as equities and sukuk. In Malaysia for instance, Ernst & Young reported that takaful operators allocated 46.5% and 28.4%, respectively, of its total funds into sukuk and equity. The allocation into equity stood at 25% in 2007. Meanwhile, in the GCC, takaful operators allocation into sukuk has increased from 11.2% in 2007 to 22.3% in 2009. This is in line with the increase in issuance of sukuk in the global market. Investment Composition of Takaful Operators in GCC and Malaysia (2009)

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Source: Ernst & Young 2.3 Society

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Takaful operators distribute a percentage of their profit in the form of zakat. Zakah is considered an important economic tool in an Islamic State or society. It provides a religiously approved method of managing the economy and finance. Zakat can be literally defined as means to "purify". It refers to the purification of a Muslim's wealth and soul. Wealth purification denotes the mobilisation of assets for the purpose of financial growth and justified distribution. Purification of the soul implies freedom from hatred, jealousy, selfishness, uneasiness and greed. Technically, zakat is a fixed proportion collected from the surplus wealth and earnings of a Muslim or a Shariah-compliant corporate. It is then distributed to prescribed beneficiaries and for the welfare as well as the infrastructure of a Muslim society in general. governor, he instructed him: "You are going to a people who were given a Divine Book. You should first of all invite them to the creed of Islam: 'There is no god but Allah, and Muhammad is Apostle of Allah'. When they have affirmed this, tell them that Allah has enjoined on them to offer Prayers five times a day; when they have affirmed this too, tell them that Allah has prescribed for them charity (zakat), which will be collected from their
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According to Abdullah ibn Abbas, when the Holy Prophet dispatched Mu'adh ibn Jabal to Yaman as

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rich people and distributed among needy and indigent people; when they have affirmed this too, you will take care not to extract from them their choicest things in zakat; and guard yourself against the curse of the oppressed, for there is no curtain between the oppressed and his God." (Bukhari, Muslim) This shows the importance of zakat as a tool or means to care, nurture and grow the society. As such, profit earned by takaful operators and paid as zakat plays an important and vital role in the development of the ummah. 3.0 Challenges The global takaful industry is relatively small in comparison to its conventional insurance counterpart. To grow unfettered, the industry needs to gain critical mass, build worldwide brand recognition and exceed performance standards set by the conventional insurance industry. The following are some of the issues that need to be addressed: Lack of global standards. In many countries, takaful took off not initially accompanied by a set of internationally recognised standards and rules. Countries like Malaysia, Bahrain and Pakistan are among the few that have introduced specific takaful laws or regulations to guide the growth of the industry in those respective countries. Bahrain has implemented AAOIFI standards for takaful companies, Saudi Arabia introduced corporate insurance rules, while Malaysia has implemented a robust regulatory regime to cater for the needs of this sector. However, to boost growth of takaful globally, particularly in non-traditional markets like US and Europe, it is useful to have uniformed regulations that work across the globe to facilitate efficient transactions. This will facilitate global marketing of takaful and cross-border activity. Lack of historical data. The industry lacks statistical data and claims experiences given that in most countries, regulations and new laws governing the industry have only been introduced in recent years. This limits the ability to estimate losses more precisely which will in turn affect pricing, as well as the capacity of industry players to innovate their product offerings. For the industry to flourish, it requires a sound system to gather, organise and present detailed data on losses and exposures. Although the availability of data is slowly
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improving over the years, more needs to be done to improve the situation. Lack of product innovation. One of the main reasons takaful has yet to gain critical mass is because the sector, globally, lacks product innovation. New products in the takaful industry are often a result of incremental innovation, and they are often offered either as a product line extension or as an entirely new product. To increase the number of products offered, takaful players need to have stronger and more in-depth understanding of the technical, operational, legal and Shariah requirements for takaful operations. Need for more retakaful capacity. Although most major reinsurers have put retakaful solutions in place, over the last three years, the capacity has been insufficient to meet demand, forcing some takaful companies to reinsure on conventional basis. Still, Shariah scholars have allowed takaful operators to reinsure on a conventional basis so long as there was no retakaful alternative available. However, this runs counter to customers preferences of seeking cover based on Shariah principles. Nevertheless, we expect this will probably change over the years as the industry expands. Expanding distribution networks. There is a need for takaful operators to expand their customer reach across multiple distribution channels. Currently, the operators rely to a large extent on their agency sales forces to distribute their products. Distribution via retail banks are done to a very limited extent. There are opportunities for takaful operators to work together with banks, which are increasingly looking to diversify their business by adding bancatakaful (Shariah-compliant bancassurance) to their portfolio of products. Such a tie-up would be highly beneficial for takaful operators, given that they would be able to ride on the banks wide distribution network and online infrastructure to reach a wider target segment. Such partnerships also offer cross-selling opportunities, for instance, with customers on the banks private banking database. Lack of takaful professionals. The global takaful industry is growing at a much faster rate than it is developing and acquiring new talent. The significant growth in the industry in the last few years, combined with the establishment of new players in non-traditional markets, is taking a toll on the sectors already limited pool of human resources. This shortage of
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takaful professionals bears paying attention to as it could stunt the growth of an industry that has vast potential. Knowledge and skills can be developed via formal training programmes as well as on-the-job training.

4.0 Conclusion The longer-term outlook for the industry remains positive, given that takaful is a viable alternative to conventional insurance for the worlds 1.5 billion Muslims. Growth of the industry will also be supported by strong demographic growth, rising income levels and a growing desire to consume Shariah-compliant products. However, for the takaful industry to continue to survive and grow in the long term, it is crucial to ensure the following are in place: The availability of Islamic investment opportunities and a liquid market for sukuk in A robust risk management and corporate governance systems for takaful operators. Adequate regulation and supervision on takaful operators and the industry. Standardisation of the operating models. A strong Shariah framework which is in line with developments in the takaful industry. This different regions.

is to enhance consumer confidence and give greater exibility for takaful operators to be innovative within the boundaries of Shariah. As such, significant investments are required to establish the Shariah board, develop technical expertise on Shariah compliance, train staff, create brand awareness among customers, as well as implement relevant systems and technology for the industry.

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References KFH Research Ltd. Global Islamic Finance Directory 2009. Kuala Lumpur. Ernst & Young. April 2010. The World Takaful Report 2010. Syarikat Takaful Malaysia Berhad website. http://www.takaful-malaysia.com.my http://www.a1realism.com/ENGLISH/BASIC/zakah_sadaqah.htm http://www.islamic-world.net/economic/main_page.html

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