Riskonomics, Uncategorized

Why Takaful is more successful in personal lines than commercial lines

While various reports and statistics show optimistic outlook on the Takaful sector, one of the most eye-catching phenomenon is that global the Takaful industry is still significantly dominated by personal lines such as family Takaful and personal general Takaful, which cover motor, personal accident, medical and householder/house owner fire.  

On the other hand, commercial lines is only a small segment in Takaful. It seems like Takaful has not been able to position itself successfully in the global commercial line segment compared to personal lines. This may be due to the inability of Takaful operators in getting the support from Retakaful to provide capacity for large commercial risks.

Why is Takaful less effective in dealing with commercial lines? To understand this, we can examine the two areas, which are – the characteristics of a risk portfolio and the characteristics of customers. 

Before doing that, let’s align our understanding on Takaful as opposed to the conventional insurance. As we know, Takaful provides protection against risk under the risk sharing principle instead of using risk transfer. Risks are shared among owners of similar risks instead of transferring it to the insurance companies. The insurance companies’ role has been reduced from being a risk bearer to a Takaful scheme manager, for which they are eligible for remuneration. Under the Wakala model, for example, this remuneration is given by way of a Wakala fee.  

Under Takaful, insureds or participants collectively act as risk bearers, not Takaful operator. The risk bearing capability of each participant are pooled and financially reflected though a risk fund or ‘Tabarru’ fund managed by a Takaful operator. The ultimate objective of the Takaful scheme is to ensure the money pooled in the risk fund is adequate to pay losses if that occur. If the money is inadequate, in principle, either the claimant receive a smaller payment or that all the participants will have to top-up the fund.

Characteristics of a risk portfolio 

Risks from Personal lines generally have the characteristics of low range or less variation of sum insured, relatively low average sum insured, large number of population and homogenous in terms of risk natures and features. As the risk is homogenous, it is easy to understand how it may transform into a loss. All these characteristics lead to low volatility and a more predictable outcome. This type of portfolio can be managed more easily by a simple pooling system of Takaful. This also explains why Takaful has managed to grow in the Personal lines segment rapidly.

Risks from the commercial portfolio have complete opposite characteristics. It has high range or high variation of sum insured, relatively high average sum insured, small number of population and heterogeneous in terms of risk natures, types, features and behaviours. All these produce rather a complex loss model. As the risk is heterogeneous, it is not easy to understand how it may transform into a loss as many factors may interact with each other in a variety of ways, leading to many loss scenarios that can prevail. 

These lead to high volatility and a more unpredictable outcome. The pooling system of Takaful may become less effective in managing this kind of portfolio. It is theoretically possible for Takaful to handle commercial risks if it can have a very big pool to absorb the high volatility of risks. Building a large Takaful and Retakaful pool that is capable of absorbing high volatility of risks is therefore the main challenge and not an easy task. Even in a conventional insurance and reinsurance, which is actually based on a virtual pool, a large enough pool can never been reached.

Perhaps, due to the risk transfer principle, building such a pool in a conventional (re)insurance is easier than in (re)Takaful. The capacity may shrink at some point of time, especially after certain major events such as a huge natural catastrophe or an economic crisis. However, there will always be a new breed of investors who are willing to pour capital into the (re)insurance industry looking for a handsome profit. 

In addition, as Takaful works on a risk sharing basis, it may look less “sexy” than the conventional insurance from the investors’ point of view. Acting as mere manager of the risk sharing scheme limits the possible revenue of an operator to just the fee-based income, such as the Wakala fee. While under the conventional insurance, all revenues are fee-based, its underwriting profit and investment belong to the company as all the risks are transferred to the company.

The concept of Qard creates another complication and makes Takaful even less attractive to investors. Qard is a benevolent loan provided by (re)Takaful operator (shareholders’ fund) to the risk fund in the situation where a risk fund is in deficit. The loan needs to be paid back from the future surplus of the risk fund. Some critics argue that a Qard has fundamentally changed the nature of Takaful, converting risk sharing Takaful back into a risk transfer insurance. 

Characteristics of customers

Participant or insured of personal lines are individual. Each individual is responsible for making a decision on how they are going to handle their risk, whether to buy a conventional insurance or participate in a Takaful scheme. This decision is very much shaped by their personal beliefs and values. A Muslim will be driven or influenced by his or her Islamic religious belief and values. Therefore, if he or she is given two choices – a conventional insurance or sharia-compliant Takaful, the probability that the person will opt for Takaful is very high. 

Even for someone who is not that religious and tend to be rational rather than emotional in their decision making, he or she may still lean towards using a Takaful solution when one is given both options with similar values. The consideration to be Sharia compliance may not be too critical for the individual, but that can be considered as a bonus factor. 

Unlike personal lines, the insureds or participants of commercial lines are organisations, and mostly commercial organisations. The element of religion cannot be used as a consideration for these organisation, unless in rare circumstances where the corporation is strongly controlled by very religious individual. The Shariah compliance sentiment is irrelevant. Almost all decisions are rational and financially driven. In these organisations, the conventional mind-set of ‘acquiring at the lowest possible cost’ applies. They tend to have the mindset of ‘grabing the upside values as much as possible and letting the other party swallow all downside risks’. Therefore, it is very much a risk transfer mentality. Marketing Takaful solution to them using the Personal line approach by addressing religious and social sentiment may not be effective. Henceforth, the Takaful operator needs to show that Takaful can provide a financially efficient solution in dealing with risk, as the alternative to conventional insurance.

(Published by Islamic Finance News (IFN), Volume 12 Issue 28, 15th July 2015)

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