Regulation of Takaful Business

Corporate Governance is a prerequisite for promotion of growth and competition in the financial services industry. It protects both customers and investors. Takaful provides an Islamic alternative to insurance and is a key component of the Islamic Financial Market. Corporate Governance establishes the quality and the credibility of Takaful Operators among the community of participants, shareholders, and employees.

Similar to Islamic Banking, one of the main distinct features of Corporate Governance for the Takaful Operator is the appointment of Shari’ah Supervisory Board (SSB). The role of SSB is to review and supervise all of the Operator’s activities to ensure compliance with Shari’ah. They are supposed to check that elements of Riba, Gharar or Maysir or other prohibited transactions do not creep into the Operator’s business. They also make sure that the financial accounting of the Takaful operator is accurate, precise, and timely. This feature of the establishment of SSB is quite different from normal governance which aims to only to protect the interests of the shareholders and investors. Shari’ah compliance has been the main value proposition of the Takaful Operators offering an Islamic alternative to conventional insurance.

SSBs face a unique challenge that the Takaful Operator is able to sell the idea of its Shari’ah complaint product to the potential participants yet match the pricing and service quality of the conventional insurance companies. The operators have to abide by the regulations set for conventional insurance in terms of capital adequacy and solvency, risk assessment, and transparency.

An additional role of SSB is to supervise the management of Takaful funds to assure that they are invested ethically and responsibly and in according to Shari’ah rules. This role helps increase transparency in terms of Shari’ah compliance. SSB also check the distribution of Mudarabah profits to assure that they are following the Takaful agreement.

Takaful industry is relatively new and standards are still evolving. The issue of governance gets more complicated when ideological differences and interpretations of Shari’ah advisors, Boards, or regulators is taken into account. An operator being supervised by one regulatory authority could offer products and services of another institution supervised by another authority. The Takaful purchaser should not have to deal with these differences and should be offered uniform set of Shari’ah compliant products across different operators. There is no uniform set of regulatory and legal framework for Takaful. Organizations such as Islamic Financial Services Board (IFSB), International Association of Insurance Supervisors (IAIS), and Accounting and Auditing Organization for Islamic Financial Institution (AAOIFI) are trying to standardize uniform governance guidelines for Takaful industry.

Shari’ah Audit

All businesses, Islamic or otherwise, aim to promote the stakeholder value and to earn their trust. A company offering Islamic financial products must demonstrate to all stakeholders that all of their activities are in compliance with Shari’ah. Shari’ah audit of a Takaful operator investigates the financial statements and accounting procedures for compliance. The audit makes the Takaful industry more transparent. The audit is done internally through Shari’ah Supervisory Board (SSB), and externally, by outside entities. The goal of the audit is to examine the records and reports of the operator to determine its soundness and adherence to Shari’ah rulings.

Takaful Operators procure the services of religious advisors to form SSB. The role of SSB is to certify Shari’ah compatibility of financial products, verify that transactions comply with Shari’ah rulings, calculate and pay Zakat, dispose of any non-Halal earnings, and advice the company on distribution of income or expenses. SSB reports on Shari’ah compliance of the institutions, which usually is an integral part of the annual report. Actual role of SSB varies across different operators from ex-ante monitoring and Zakat calculation to ex-post monitoring.

If SSBs are involved in internal audit, their independence has to be assured. Many scholars belong to more than one SSB. This could raise the issue of conflict of interest as they will have access to proprietary information of competing institutions. The SSB members required to do internal audit should be conversant in both Shari’ah as well as commercial and accounting principles. This dual expertise is hard to find. Some companies resolve this by including different experts in the SSB but that could lead to differing opinions and communication problems. Another concern about Shari’ah audit is that differing interpretations of Shari’ah could lead to conflict. This is where standardization bodies such as Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) play a crucial role.

To guarantee independence of internal Shari’ah audit, most Islamic financial institutions have established independent internal Shari’ah review units or as a part of the internal audit or control department. Further, independence of internal audits, either through SSB or review units, can be assured by empowering them to have access to all records and staff, requiring management to respond to queries, and taking corrective actions to rectify any negative audit findings.

The diverse opinions of scholars on Shari’ah issues provide a dynamic innovative environment for financial products. However, this diversity has led to inconsistencies across various SSBs which create confusion in the market. External audit can being certain level of standardization in compliance. These may include regulators, external financial information services providers, or rating agencies to assess Shari’ah compliance of Takaful instruments and processes. External providers offer a wide array of expertise and independence to gain the confidence of all stake holders which is not possible through internal sources.

1. Discuss and comment on some of the regulatory implications identified by the Islamic Financial Services Board because of the difference between the operations of Takaful and conventional insurance.

Regulatory Implications

The Islamic Financial Services Board (IFSB) has identified the regulatory implications of the differences between Takaful and conventional Insurance. The regulations developed for conventional insurance are not universally applicable to Takaful business. In some jurisdictions, specific regulations tailored to Takaful and other Islamic financial services may be required. Where that is not feasible, special consideration should be given to the regulation of Takaful business. Some of the implications highlighted by IFSB are as follows:

• A Takaful Operator must provide assurance of Shari’ah compliance in all its operations. This is normally done through a Shari’ah Supervisory Board (SSB). Appointment of SSB helps earns the confidence of all stakeholders that the operator is actually offering an Islamic alternative to insurance. The regulators need to either work with the Operator’s SSB or establish own SSB to deepen the understanding of Shari’ah compliance for Takaful.
• Takaful is based on mutual cooperation of contributors. Thus, family Takaful operates on a defined contribution instead of defined benefits which is the case with conventional life insurance. Unlike life insurance, there are no guarantees of maturity, surrender or death benefits. This changes the risk profile and impacts the capital adequacy and disclosure requirements. Regulatory authorities need to be aware of this difference.
• The solvency requirements need to address the difference between a Takaful Operator and a conventional insurance company. The mechanism of funding underwriting deficit should take account of the source of such funds identified in the Operator’s charter. It could be in the form of Qard Hasan from the operator or from the investment funds. Further, to what extent policyholders’ funds versus stockholders’ funds would be used, needs to be identified.
• Sharing scheme and distribution of surplus and deficit funds with the policyholders should be transparent. This is to avoid Gharar (uncertainty) in Takaful contracts.
• Due to the requirement of Shari’ah compliant investing, the entire universe of securities and investment vehicles is not available to Takaful Operators. For example, they cannot invest in interest bearing securities and certain prohibited businesses such as alcohol, financial services, casinos, etc. They also avoid certain derivative products which are not approved by their Shari’ah Boards. Regulations need to take into account the Takaful Operator’s different risk profile as compared to a conventional insurance company.
• The structure of a Takaful Operators quite different from a normal for-profit insurance company. The Operator may work under one of the Shari’ah compliant structures of Mudarabah, Wakalah, Waqf or a hybrid of these. The regulations should accommodate these structures and their associated risks. This may also impact licensing of Takaful companies.