BFI

Munich RE.

Takafu( and~etakafuf'Ach"ancedPrincyles

andPractices

TOBIAS FRENZYOUNES SOUALHI

Second:Edition

Published by

IBFIM

Kuala Lumpur2010

Munich Re

Published byIBFIM 063075-W)3rd Floor, Dataran Kewangan Darul Takaful,Jalan Sultan Sulaiman, 50000 Kuala Lumpur, Malaysia.Tel.: 603-2031 1010 Fax: 603~2031 4250www.ibfim.com

Second Edition 2010© Munich Re 2010

All rights reserved. No part of this publication may be reproduced.duplicated or copied by any means without the prior consent of theholder of the copyright. While every care is taken in the preparation otthis publication, no responsibility can be accepted for any errors, howevercaused.

Publication Manager: Mohd. Zain Abd. Rahman

Perpustakaan Negara Malaysia

Frenz, Tobias.

Cataloguing-in-Publication Data

Takaful and retakaful: advanced principles and practices I TobiasFrenz and Younes Soaulhl. Kuala Lumpur: IBFIM, 2010.

p.ISBN 978-983-43777-9-3 {pbkJISBN 978-967-0149-02-8 {hbd)

Printed in Malaysia byPercetakan Mesbah Sdn Bhd (819193-K)No. 11, Jalan Tun Perak 6. Taman Tun Perak,43200 Cheras, Selangor Darul Ehsan.Tel: 03-91056473 Fax: 03-91056469

TABLE OF CONTENTS

FOREWORD _ _._ .. __ i

PREFACE _ _ _ _ iii

1 ISLAM

1.1 Origin _ _ __ 3

1.2 Keymovements _ _.. _ 5

1.3 WorldwideMuslimcommunity __ .. _ _ 6

1.4 OriginandcollectionoftheQur'an 6

1.4.1 Translations __ __ .__ __ __ __ __ __ __ __ __ 7

1.4.2 AnoteonArabic .. __ __ _ 8

1.5 Sunnahandhadith. __ .. __ .. __ _.._.. __ . __..13

1.6 Foundationsoflslam .. _.. __ ._ _ __ .. __ __ ..15

1.7 Sixarticlesoffaith_ __ __ __ __ .. __ .15

1.8 Fivepillarsofislam __ __ . __ .. __ .. 16

1.8.1 Ahkampentad __ .. __ .. __ .. __ __ 20

1.8.2 Darurahornecessitydoctrine __ 21

1.9 TheShari'ah __ .. __ __ .. __ .. __ __ 22

1.9.1 ObjectivesofShari'ah {maqasidaI-Shari'ahL _ _ 22

1.9.2 Islamicjurisprudence. __ _ __ __ .__ . __ __ 24

1.9.3 Islamic schools of juris prudence __ __ .. __ __ 29

1_10 Bridgingdifferencesincontemporary Islamicfinance __ .. 33

1.10.1 Thedoctrineofal-khurujminal-khilaf(resolvingdisputesl 33

1.10.2 Guidelines and parameters of dispute resolution inIslamic finance _._. _._. _._ .. __ 35

1.10.2.1 DiversificationofShari'ahcontractsand instruments ...36

1.10.2.2 Considering the opposite view 37

1.10.2.3 Ignoring weak views __ ..41

1.10.2.4 Reviewing classical views that may be irrelevantto Islamic banking and finance .. __ .42

11111111 v

1.10.2.5 Proper understanding of complex financialproducts .42

1.10.2.6 Minimising debt based products and promotingequity based products 43

1.10.2.7 Finding a balance between the maqasid and textualmodes of ijtihad in islamic finance 43

2 Islamic Finance

2.1 Objectives of Shari'ah in Islamic finance 50

2.2 Islamic banking 51

2.3 Islamic capital market 54

2.4 Takaful business performance 55

2.5 History of Islamic finance .55

3 Islamic Commercial Contracts

3.1 Contract requirements _ _ _..61

3.1.1 Valid and invalid contracts _ _ _ _ 62

3.1.2 Amalgamation of contracts 63

3.1.3 Substance over form 64

3.2 Contract classification 65

3.2.1 Unilateral contracts _ _ _ _ _._ 65

3.2_1.1 Gift (Hibah) _ _ _._._._ _ _._ _ _ _ 65

3.2_1.2 Waiver (TanazulJ _ _ _._._._ _ _ _ _ 66

3.2_1.3 Donation (Tabarru'J __ .._ 66

3.2.1.4 Promise rWa'dJ _ 67

3.2.1.5 Rebate (Ibra') 67

3.2.1.6 Will (Was;yvah) 68

3.2.2 Bilateral contracts _ 68

3_2.21 Partnership or equity based contracts 68

vi 11111111

3.2.2.1.1 Musharakah. 68

3.2.2.1.2 Dirninishingmusharakah 71

3.2.2.1.3 Mudarabah .72

3.2 .2.2 Salescontracts 73

3.2.2.2.1 Trustsales 73

3.2.2.2.2 Sales for future delivery 74

3.2.2.2.2.1 Salam 74

3.2.2.2.2.2 fstina' 75

3.2.2.2.3 Bay'aVurbun 75

3.2.2.2.4 Sarl 76

3.2.2.2.5 Bay'al-'inah. 77

3.2.2.2.6 SSA. 78

3.2.2.2.7 SBA with variable profit rate 78

3.2.2.2.8 Bay'a/-dayn 79

3.2.2.2.9 Tawarruq 80

3.2.2.3 LeasingContracts 81

3.2.2.3.1 Leasing{fjarah} B1

3.2.2.3.2 Financial lease 82

3.2.2.3.3 Forward lease 82

3.2.2.4 Financing by concept in Malaysia 83

3.2.2.5 Supporting contracts 83

3.2.2.5.1 DebttransferfHiwalah} 84

3.2.2.5.2 Guarantee(Kafalah} 84

3.2.2.5.3 Pledge(Rahn} B5

3.2.2.5.4 Loan (Oardhasan} 85

3.2.2.5.5 Agency contract (Wakafah) 86

3.2.2.5.6 Commission contract rJu'afah) 87

3.2.2.6 IslamiC accounts and deposits .87

3.2.2.6.1 Wadi'ah yad damanah accounts 88

1111I11I vii

3.2.2.6.2 Qard accounts 89

3.2.2.6.3 Mudarabah deposits 89

3.2.3 Islamic credit cards 90

3.3 Islamiccapitalmarkets 91

3.3.1 Equities _ 92

3.3.1.1 Stockscreening 93

3.3.1.2 Example 95

3.3.1.3 Preferential shares 97

3.3.1.4 Purification process 97

3.3.2 Sukuk 98

3.3.2.1 Tradabilitv 100

3.3.2.2 Typical sukuk structure 101

3.3.2.3 Sukuk issuance -taxation issues 102

3.3.2.4 Types of sukuk l 02

3.3.2.5 ljarah sukuk 103

3.3.2.6 Mudarabah sl1kuk 105

3.3.2.7 Musharakah sl1kuk 106

3.3.2.8 Murabahah sukuk 107

3.3.2.9 Hvbrid sukuk 108

3.3.2.10 Controversial features of sukuk 109

3.3.2.10.1 The repurchase undertaking 109

3.3.2.10.2 Guaranteed regular distributions 110

3.3.2.10.3 True ownership of assets 112

3.3.3 Islamicderivatlves 112

3.3.3.1 Futures and forwards 113

3.3.3.2 Options 113

4 TAKAFUL

4.1 Risk management under Islam 117

4.2 Why is conventional insurance unlawful? 118

viii 11111111

4.2.1 Riba _ __118

4.2.2 Gharar 120

4.2.3 Maisir.. _ 123

4.2.4 Haram _ _ 122

4.2.5 Conclusion _ _ 122

4.3 A Shari'ah compliant alternative to insurance 123

5 TAKAFUL OPERATION

5.1 Legal structure 128

5.1.1 NOll-profit company 128

5.1.2 Commercial company _ _ 129

5.1.3 Models of Islamic insurance in selected countries 130

5.1.4 Source of Capital... 131

5.2 Takaful operational models 132

5.2.1 Segregated Funds 134

5.2.2 Tabar(U· __ __ 135

5.2.3 TakafuIBenefits.. __ __ __ __ 135

5.2.4 SurplusSharing __ _ __ 136

5.2.4.1 M utual!cooperative. for-profit insuranceCompany..136

5.2.4.2 Pure wakalah model... __ .. __ 137

5.2.4.3 Wakalah model with performance incentive 139

5.2.4.4 Riskmanagementcharge __ __ __ .. __ .. __ ..141

5.2.4.5 Mudarabah model .. __ __ 141

5.2.4.6 Hybrid wakafah mudarabah model. __ .. __ .. __ .143

5.2.4.7 Waqf model. __ .. __ .. __ __ .. __ 144

5.2.4.8 Wadl'ah model. __ __ __ .. __ 146

5.2.4.9 The modelofchoice __ 147

11111111 ix

5.3 Technical foundations of general takaful and retakafuL 149

5.3.1 An analysis of participants' behaviour 151

53.2 Irrecoverable qard hasan, reserving and risk modelling 152

5.3.3 Modelling expected qard hasan repayments 155

5.3.4 Pooling 155

5.4 A tentative takaful typology and its results 158

5.5 Markets and niches for the different takaful types 159

5.5.1 Risk transfer and modeling 160

5.5.2 Where risk sharing flourishes 160

5.5.3 Shari·ahcomplianceofthetakafultypes 161

5.5.4 Maintaining the separation of funds in high

volatility business 162

5.6 Technical aspects 165

5.6.1 Dripping under family takaful 165

5.6.2 Family takaful operating fund 166

5.6.3 Ownership of the takaful fund 169

5.6,4 Surplus distribution 169

5.6.4.1 Distribution of underwriting surplus 171

5.6.4.2 Sharing of underwriting surplus 171

5.6.4.3 Ways of allocating surplus 176

5.6.5 Claims contingency reserve 178

5.6.5.1 How is the CCR bUilt up? 179

5.6.5.2 Is there a cap on the CCR? 180

5.6.6 Surplus sharing examples 181

5.6.7 Model examples 182

5.6.8 Oard hasan 184

5.6.8.1 Legal nature of the qard 185

5.6.8.2 Cash or asset assignment? 187

5.6.8.3 Issues with the qard hasan 187

x 1111I11.

5.6.9

5.6.10

Shari'ah supervisory board _ 188

Treatment of takaful in annual reports 190

5.6.10.1 Reporting in Malaysia __ .. __ .. __ __ .. __ 190

5.6.10.2 Takaful under IFRS__ .. __ .. __ __ 192

5.6.11 Solvency and risk: based capital __ 193

5.6.11.1 Evolution of solvency models __ .. __ .. __ __ 194

5.6.11.2 Rating agencies' view of capital adequacy .. __ 201

5.6.11.3 Shari'ah quality rating.. __ __ .. __ __ 201

5.6.11.4 RBC for takaful - Is it any different? .. __ ..202

5.611.5 Valuation of liabilities __ .. __ .. __ 210

5.6.11.6 Funding of risk capital charges __ .. __ __ .210

5.6.11.7 IFSB exposure draft on solvency requirements

undertakings for takafuL __ .. __ __ 212

5.6.11.8 Risks specific to takaful __ __ .. __ 216

5.6.11.8.1 Market and credit risk __ __ .216

5.6.11.8.2 Liability risk __ . 217

5.6.11.8.3 Operational Risk _ __ .217

5.6.11.8.3.1 Shari'ahcompliancerisk...218

5.6.11.8.3.2 Fiduciary risk __ .. .__ 220

56.118.3.1 Reputational risk... __ .. __ 221

5.6.11.8.4 Displaced commercial risk __ .. __ .. 221

5.6.11.9 Solvency models in selected takaful markets __ 222

5.6.12 Takaful standardisation __ .. __ .. __ __ .. __ .. __ .. __ 224

5.7 Takaful at a glance __ __ .. __ .. __ .. __ .. __ 226

6 TAKAFUL MARKETS

6.1 Selected takaful markets.. __ .. __ .. __ .. __ .. __ __ 229

6.1.1 Malaysia __ __ __ __ .229

6.1.2 Brunei __ .. __ .. .__ __ .. __ .231

mum xi

6.13 Indonesia. 231

6.1.4 Labuan 232

6.1.5 Pakistan 232

6.1.6 Bangladesh 233

6.1.7 Bahrain 233

6.1.8 Singapore 233

6.1.9 Oatar. 234

6.1.1 0 Sudan 234

6.1.11 United Arab Emirates 234

6.1.12 United Kingdorn 235

6.1.13 Kingdom of Saudi Arabia 236

6.2 Regulatoryoverview 236

6.3 Shari'ah parameters for takaful lwakafahl 237

7 RISKS AND CHALLENGES

7.1 Regulatory conSiderations 241

7.2 Limited data 242

7.3 Competition with conventional insurers 243

7.4 Cannibalisation 243

7.5 Market approach 244

7.6 Marketing 245

7.7 Distribution 246

7.8 Products 249

7.8.1 Pricing 250

7.8.1.1 Pricing methodology 250

78.1.2 PriCing basis 250

78.2 Underwriting 251

7.8.3 Contract wording/marketing material 252

xii 11I11I11

7.8.3.1 Compensation for late payment 253

7.8.3.2. Exclusions .254

7.8.3.3 Guarantees .255

7.8.3.4 Ex-gratia payments 255

7.8.3.5 Nomination under family takaful 256

7.9 Islamic investments 257

7.10 Shari'ah oompliance 258

7.11 Staffing 258

7.12 Evolving regulations and accounting standards .259

B RETAKAFUl

8.1 The current retakaful market.. 264

8.2 Types of retakaful arrangements 266

8.3 Legal structure 271

8.4 Operational modeL .272

8.5 Pricing considerations 275

8.5.1 Wakafahpricingworkflow. .276

8.5.1.1 Proportional pricing (original contribution basisf 277

8.5.1 .2 Non-proportionalpricing(Riskcontributionbasisl 278

8.5.2 Commission and brokerage 279

8.5.3 Wakalah fee 281

8.6 Pooling 282

8.7 Current limitations and solutions 287

8.8 Claims contingency reserve and surplus sharing 287

8.8.1 eCR examples 291

8.8.2 Surplus distribution formula for pooled business 292

8.9 Retrotakaful. 295

8.1 0 Screeningprocess 296

8.11 Need for standardisation and haRmonisation 297

11I1I11I.kafu! and Retakafu! - Advanced Principles and Practices XIII

812 Financial retakaful and securitisation 298

8.13 Recapture of family takaful business 302

8.13.1 Recapture under the Shari·ah 304

8.14 Getting takaful operators to chose retakaful first 308

9 APPENDIX

9.1 Shari'ah parameter for takaful (wakalahJ 317

9.2 Islamic finance interest groups 325

9.3 Glossary 328

9.4 Abbreviations 331

9.5 Bibliography 333

xiv Takaful and Retakaful - Advanced Principles and Practic..l1ll1l1: