S&P raises some interesting questions about takaful

While Standard & Poor's has taken some heat recently with the downgrade of the US credit rating, it still does provide some interesting insights in other research, specifically in an article on takaful.  S&P writes:

We note that the IFSB Standard 11 requires the separate solvency monitoring of takaful funds from shareholder (operator) funds. As takaful funds are the sole responsibility of the members (contributors), we see some regulatory logic in this, although in our view this seems to ignore the role of the shareholder in its active support and management of the takaful fund, as demonstrated through the provision of qard hassan (interest free loans), solvency margin and capital employed.

In its interactive ratings of takaful companies, Standard & Poor's is of the opinion that there is real fungibility from shareholder funds (and the attaching assets) to the takaful fund if the latter is in deficit (unless demonstrated otherwise). At the early stages of a company's development, when takaful fund deficits could be likely, this standard could create an onerous set of operational constraints.

The key issue that S&P is highlighting is that legally the shareholder's funds (the takaful provider's equity capital) is separate from the takaful fund, which is owned by the members and invested on their behalf to pay for claims by members.  However, if the premiums paid plus gains on the investments minus claims is negative (the fund is in deficit), the shareholder's fund will extend an interest-free loan to cover claims; members will not be called upon to cover the deficit when it occurs. 

The importance for a ratings agency of this structural contradiction is that technically it is rating the ability of the takaful fund to cover anticipated losses or the takaful company's ability to continue operating based on its management fees for managing the takaful fund.  It complicates the rating process if the two separate accounts have loans between them because it creates a hidden liability for the takaful company, should the takaful fund go into deficit.  

This problem goes side by side with the characterization of the takaful fund as being owned by its members, who should have a right to the surpluses in the takaful fund.  S&P writes: 

Where the risk profile of the takaful fund is homogenous, then we believe the establishment of and distribution of surpluses to members should be uncontroversial. However, as the takaful sector grows in scale, it will increasingly seek to underwrite larger risk values in more commercial sectors, for example, marine and aviation. Although use of retakaful capacity can control loss exposures from high-value covers, we question the feasibility of a single takaful fund comprising such a heterogeneous mix of risks.  

In a homogenous takaful pool with insured risks that occur more regularly, but have low dollar figure claims when they occur.  In this case, there is less likely for the fund's gains over several years to be wiped out by one outsized event.  In this case, the takaful fund can pay out surpluses annually to its members (often by reducing the premiums for the next year).  However, if this small claim amount with frequent occurrence is combined with larger takaful products like marine insurance, where the insurance is less likely to be claimed each year, but the amount if it were to be claimed is substantial (likely multiple times of a regular year's surplus).  

In this case, even though members legally own the surplus, it would not be prudential for the surplus to be paid out each year because there is a chance of a large claim in any given year (from the marine insurance) that would leave the fund in substantial deficit, which would eventually be made up by future surpluses being used to cover the deficit and leaving nothing for several years to pay out to the members at the time.  This would amount to a transfer of surpluses to current members from future members (who might not be the same).  In my mind, the easiest solution would be to have different funds for different types of insurance so that one set of members could receive surplus payouts each year (if there is a surplus) and other funds could withhold surpluses to cover potential future deficits, although I suspect there are some Shari'ah issues with the takaful fund withholding surpluses from members.

S&P concludes with a sentiment that is often talked about in Islamic finance, but is often lacking in practice: defining the value proposition for Islamic finance compared to its conventional alternative.

In our view, the successful development of the takaful sector depends on the identification and promotion of a real value proposition that is distinctive from that being offered in the conventional insurance sector.

This is a challenge for the industry as a whole, but with a shorter track record for takaful, there could be fewer entrenched ideas making it easier to change the way things are done than in the banking or finance industry.