Takaful Surplus Distribution: A Controversy
by. Delil Khairat
Takaful is an alternative risk management tool offered by Islamic Fiqh to replace unacceptable conventional insurance. It is based on risk sharing and sincere acts of helping fellow human beings. However the holy concept is clouded by short term tactics of surplus distribution.Conventional insurance operates on a platform of risk transfer, where an insured simply transfers a part or all of their risk to an insurance company (insurer) and pays a certain amount of money, called a premium. It is basically a contract of buying and selling. The insured buys insurance protection sold by the insurer, and pays a premium as the price. By doing so, the insured is replacing his ‘uncertainty’ to an amount of ‘certainty’ as much as the premium paid.
Unfortunately, the risk transfer mechanism of conventional insurance is not acceptable to most Islamic scholars. Transferring risk (uncertainty) to other parties in return for a premium is challenged because it brings at least two forbidden elements to the contract, namely Gharar (uncertainty) and maisir (speculation).
Under Islamic law, any contract of sale involving Gharar is prohibited. Risk itself is a kind of Gharar in nature, so managing it under a contract of sale is prohibited. Furthermore, the insurance company who receives the premium and agrees to bear the risk is committing a maisir (speculation), as its fortune depends on the chance that a loss may or may not occur. On the other hand, Riba (usury) especially in investment activities, is the other element that makes conventional insurance unacceptable. Hence, Takaful has emerged as an alternative mechanism to replace the prohibited conventional insurance.
Under Takaful mechanism, risk is not transferred to the insurance company, but shared among all owners of a similar risk. First of all, someone who has a risk joins with others who have similar risks and they all form a group, community or pool. The members then agree to make a contribution that must be commensurate to each risk brought into the pool. The contribution/fund is pooled and used to indemnify certain members who suffer a predefined loss.
Under the Takaful concept, the company is not a risk taker, but merely acts as a third party who is employed by members to manage the pool and to ensure the scheme of ‘helping each other’ runs effectively and fairly. That is why insurance companies now call themselves ‘Operator’, instead of ‘Insurer’ and members are called ‘Participant’, not ‘Insured’.
Certainly, as a commercial entity, an insurance company is not going to do all those things for free. They deserve a certain amount of fee for the expertise, competence and resources deployed in managing the portfolio. How this fee would be calculated or when the operator receives it is very much determined by type of Aqad (contract) between operator and participants. Mudarabah and Wakalah are the two most popular contracts used to operate Takaful.
Surplus distribution under Mudarabah model
In the earlier days of Takaful, when the first Malaysian Takaful operator introduced their product, Mudarabah was the first operational model.
Mudarabah is an ancient form of financing practised by the Arabs since long before the advent of Islam. When Muhammad (peace be upon him) began his prophetic mission, he did not interfere and the let Arabs continue practicing it. This was because Mudarabah does not involve the denial of the existence or the uniqueness of the one God (Allah) or associate anything or anyone with Him or was against any command of God.
Mudarabah is defined as a contract between two parties, where one party gives money to another for investing it in a commercial enterprise. The first party is called ‘rab-ul-maal’, while the management and work is an exclusive responsibility of the other, who is called ‘Mudarib’. When it applies to Takaful, participants are ‘rab-ul-maal’ and Takaful operator acts as ‘Mudharib’.
Mudarabah is a commercial contract, so the provision or condition on profit is a main pillar. It is necessary for the validity of Mudarabah that the parties agree, right at the beginning, on a definite proportion of the actual profit to which each one of them is entitled. There is no Mudarabah without profit sharing. If a business incurs loss in some transactions and gains profit in others, the profit will be used to offset the loss at the first instance. The remainder, if any, shall be distributed between the parties according to the agreed ratio.
When Mudarabah is deployed in a Takaful contract, profit sharing has to be embedded; otherwise the contract will be invalid. However, the non-profit nature of the Takaful concept has brought hesitation on the use of the word ‘profit’. Hence, the word ‘surplus’ is used. And surplus distribution is introduced to replace profit sharing.
Surplus distribution under Wakalah model
As the Takaful concept became more advanced, many raised objections on the application of Mudarabah to the Takaful contract. Most people view that running a Tabarru’ (non-profit) scheme with a commercial contract is a contradiction. Some further challenge that distributing a surplus is against the very basic aim of pooling the fund. Participants contribute to the fund at the outset with the pure intention to help fellow participants when a predefined misfortune occurs, not expecting any return. No economic motive is involved.
At the same time, a new model of Wakalah emerged and rapidly gained its popularity. Wakalah is an Arabic word for delegation or representation. Wakalah is a contract when a person appoints a representative to undertake transactions on his/her behalf.
Similar to Mudarabah, the relationship among participants remains under Tabarru’ (donation/non-profit) principle. The difference lies on the relationship between participants and the Takaful operator. Under the Wakalah model, the Takaful operator acts as an agent of participants to conduct certain tasks for a certain fee. It is important to note that in its original form under Islamic Fiqh of Muamalat, the Wakalah contract does not have any element of profit sharing or surplus distribution.
Interestingly however, surplus distribution does not suddenly disappear when Takaful operators migrate from Mudarabah to Wakalah. It remains as part of many Takaful products. The Takaful industry has obtained legitimacy for surplus distribution under the Wakalah model. The argument behind it is that funds in the pool are collectively owned by participants (although this thesis can be challenged too), so it is their right to decide how to treat any surplus, should it exist. A statement in the proposal form or policy schedule that state participants give their permission to the operator to distribute surplus is as good as authorization.
Furthermore, Takaful operators also found justification for them to receive a portion of surplus distribution by treating it as performance fee for excellent management of risk portfolio. This makes surplus distribution identical in both Wakalah and Mudarabah.
Takaful is Insurance with Surplus distribution
Since it was first introduced under Mudarabah, surplus distribution has become a major selling point of Takaful, irrespective of the operational model used. Marketers began to tell their customers that Takaful is better than conventional insurance because at the end of the period, they will get their money back. Slowly but surely, misunderstanding developed among the general public that Takaful is basically insurance with surplus distribution. Surplus distribution simply overshadows the holy concept of Tabarru’ or risk sharing which should be at the very centre of Takaful.
The incorrect idea that Takaful must have surplus distribution has forced Takaful operators to attach it to all products. Otherwise they will feel unable to compete in the market. This less than ideal situation of having surplus distribution under a Wakalah contract is not because Takaful operators do not understand the principle of Islamic Fiqh of Muamalat. Let’s not forget that each and every Takaful entity must have scholars sitting on their Shariah supervisory board.
Is Surplus distribution technically viable?
From a technical point of view, surplus distribution may not be appropriate for a majority of Takaful products. If we are talking about family Takaful products with a saving element, profit sharing under Mudarabah will perfectly fit, but only the saving/investment part. However, when we turn to a range of general Takaful products, none has such a saving or investment element. The only pool managed by a Takaful operator is the risk pool, to anticipate any misfortune that may bring monetary loss to the eligible participants.
If the product is a mass product with relatively homogeneous nature of risk and value within the portfolio, there may be a relatively fair to high potential of the pool resulting in surplus, mainly because it is less volatile and easier to predict and manage. But, again, it is not a sufficient reason to distribute surplus to participants and/or operators.
Unfortunately, the business of insurance or Takaful is not as simple as running a local store where profit can be defined with minimum uncertainty as turnover less purchasing cost and other expenses.
In insurance or Takaful, the ‘commodity’ managed in the pool is risk, the uncertainty itself. Obtaining good results in any particular year is not a guarantee for the same in the next year. In fact it can be very different. This volatility forces Takaful operators to build reserves during good times to anticipate bad ones in the future. In other words, not all surpluses are declared, part or even all of it must stay in the pool. It is not unusual if a risk portfolio is running in deficit the first few years of its establishment simply because of the necessity of building high reserves, not because the claim exceeds the premium.
Only after a certain period of time, when reserves in the pool is actuarially considered as abundant (more than enough), it can be released and declared as surplus. In many cases, this abundance of reserve may never come true due to the volatility of results from time to time. Imposing a mechanism of surplus distribution into this kind of portfolio is certainly an unsustainable measure.
Another important aspect to consider is pressure from the regulators that is becoming more rigorous in order to protect the interest of insureds/participants and the national/regional economy in general. Regulators recently tend to review their solvency requirements and put more pressure on capital. The draft of IFSB on Takaful solvency has shown this phenomenon. Once this draft is a published standard and is adopted by regulators, the Takaful industry shall feel the impact of a stricter solvency regulation. Always bear in mind that to ensure the same level of security, Takaful undertakings have to be subject to the same vigilant solvency requirements and other aspects of regulation as its conventional counterpart.
All these factors will force Takaful operators to put aside more reserves on their pool. They also have to have high capital to support the pool and prepare to inject Qard Hasan into the pool. Furthermore, competition among operators in the market will never relax. And, last but not least, the Takaful industry is still struggling with limited scale and lack of availability of Shariah compliant investments. With all this pressure, it is hard to see any insurance or Takaful company producing high profit or surplus from their operations. Hence, surplus distribution will not be a viable and sustainable proposition.
It is interesting to see that surplus distribution is spread to re- Takaful, even though surplus distribution is even more implausible under it. Re-Takaful mainly deals with high risk in terms of value and volatility. One of the main purposes of any Takaful or insurance company to take out re-Takaful is to transfer a large part of the volatility within their portfolio to retakaful or reinsurers and leaving them with more homogeneous and stable retained portfolios to manage. Unfortunately, we have seen some re-Takaful contracts contain the clause to accommodate surplus distribution, although no information so far suggests whether any company has successfully done it.
It is now time for the whole industry to review this misconception and begin efforts to re-educate the market and the public, especially to promote the real value of Takaful such as pooling resources to help each other without expecting any profit in return. It is very important to clarify that surplus distribution is not an integral part of the Takaful scheme. Absence of it will not make Takaful invalid as far as Shariah compliance is concerned. Even schemes without surplus distribution should be technically more sensible, robust and provide better security to the participants and economy in general.
Re-Takaful practitioner of a global reinsurance group