The question of whether takaful involves risk transfer or risk sharing is fundamental to the accounting of takaful. It is not satisfactory to just say that takaful is about risk sharing and yet it is accounted as risk transfer. You know that there is risk transfer being accounted under IFRS 17 when the Revenue Account at the Takaful Entity (TE) level shows an Expected Claim together with a Risk Adjustment.
One reason given by some as to why insurance is no different to takaful is, similar to takaful there can be statutory funds within an insurance entity. The requirement for statutory insurance funds is common in many jurisdictions. They entail the segregation of assets and liabilities within the reporting entity as separate funds. The simplest form is where the shareholders’ funds are separate from the insurance funds. In a composite insurer (where both life and non-life insurance are transacted) statutory funds could be established to separate out life insurance business from non-life. We have, however, seen jurisdictions where even for composites, such separations are not required by law and it is still business as usual. Within a life fund there could also be established a separate statutory with-profits fund for the with-profits business. So the first question I will try to answer in this posting is the difference between statutory funds in insurance and a takaful fund.
There are generally two types of insurance operating models: the Mutual company, where the company is owned by its policyholders, and the Stock company where the company is owned by its shareholders. We will consider the role of statutory funds in Stock companies. In the Stock insurance company there is a transfer of speculative risk to the insurer. In exchange for the premiums paid by the policyholders, the insurer promises to pay the insured the sum covered should the insured event happen. The insurance company turns a profit when the total premium collected is greater than the total claims and expenses incurred. In the case of a with- profit business the eventual sum assured payable may be linked directly or indirectly to the performance of a pool of underlying assets. That pooling of assets does not have to exist but needs to be defined. In the case of the traditional (UK) with-profits fund, the actuary smooths the policyholders’ bonuses over time. This smoothing is not perfect and in the end does not totally distribute all the returns earned from investing (specifically for the with-profits fund) the policyholders’ premiums, resulting in the creation of the inherited Estate.
The presence of statutory funds in insurance does not detract from the fact that all assets of the Stock insurance company belong to its shareholders. The net assets of the insurer, however, are the difference between total assets (in the shareholders’ fund and the various statutory funds) and the insurer’s total liabilities (inclusive of what was promised to the policyholders). We can term these net assets as “residuals”. As proof to this fact, witness the several distributions of inherited Estates in with-profits funds to shareholders that took place in the UK in the 80s and 90s. Also consider what happens in a demutualisation; we see the policyholders in the Mutual giving up ownership to all the assets in the mutual fund in exchange for a small cash consideration and a promise by the new owners to pay the insurance benefits when due. Thus, it follows that in the winding up of a Stock insurance company any residual assets belong to shareholders regardless of which statutory funds those residuals reside in.
In takaful it is different. The contribution (the premium) is split between the Operator fund and the takaful fund. The assets in the takaful fund do not legally belong to the Operator. In any winding up, any residuals in the takaful fund does not belong to either the Operator or the participants. It can, however, be paid to the participants but this option would be determined by the takaful Sharia Board and can instead be paid to charity. It is highly unlikely that the Sharia Board would consent to the payment of any portion of this residual to the Operator. So, you see, there is a fundamental difference between the statutory funds in a Stock insurance company and a takaful fund. In a Stock insurance company all the statutory funds belong to the shareholders from which it promises to pay the insured amount, while in takaful only the Operator fund belongs to the shareholders.
To go back to basics, we turn to the nature of the takaful contract. In Sharia law, the legality of a commercial contract is entrusted to the use of a range of pre-screened sharia-compliant “contract types”. For example, under the wakala contract one party acts in the capacity as the agent to another party in completing a particular task for a set fee. A contract type thus pre-defines the nature of the performance agreed by the parties to the contract; only the financial terms are then left to be agreed. In takaful the two contract types commonly in use are the wakala contract and the mudharabah contract. These are bi-lateral contracts in that it involves two contracting parties. There is in addition a unilateral “contract” in takaful; this is the “tabarru” or donation. The tabarru’ is the risk premium that is paid to the takaful fund from which claims are paid. It is because the risk premium is deemed a donation that any residuals in the takaful fund do not automatically accrue to the participants.
Commercial contracts, however, are drawn in accordance to the law of the land. In most jurisdictions where takaful is practiced, that is not Sharia law but either codified law or common law. Takaful contracts drawn in the law of the land are therefore unlikely to fully reflect the essence of these contract types. Thus, interpreting the application of IFRS 17 to takaful strictly by form rather than substance is unlikely to fully reflect the economics of the transaction. In essence, takaful is a multi-party contract while insurance is a bi-lateral contract. Notwithstanding this, we often see takaful contracts being interpreted as just bi-lateral contracts i.e. a contract between the “insurer” (in this case the Operator) and the “policyholder” (the participants). In fact, in takaful there are actually three parties to the contract: the Operator, the takaful fund and the participants. Of the three parties, the takaful fund is not a legal entity by itself. This however should not prohibit the takaful fund from having its own set of accounts. Indeed IFRS CF 3.10 explains that a reporting entity is an entity that is:
“….required, or chooses, to prepare financial statements. [It] can be a single entity or a portion of an entity or can comprise more than one entity. [It] is not necessarily a legal entity”.
This definition then clearly does not preclude having the takaful fund as a reporting entity under IFRS 17.
The takaful fund can best be described as a mutual entity; the mutual entity accepts risk from each policyholder and pools that risk. Although takaful participants bear that pooled risk collectively because they “hold” the residual interest in the entity, the mutual entity is a separate entity that has accepted the risk. As mentioned in Part 3 of this series of postings, the question arises as to how to account for the contract at the TE level. To do this we need to start at the basic level.
Those who insist that takaful involves risk transfer argue that the lowest unit of account in IFRS 17 is the contract that includes all insurance components. That other than in a specific set of circumstances, you cannot break down this contract into smaller insurance components for measurement purposes. They follow on to conclude that the takaful contract does not meet these specific criteria. However, it should be pointed out that the set of circumstances listed in IFRS 17 are non-exhaustive. Let us therefore, for the sake of argument, assume that the splitting of the takaful contract is allowed under IFRS 17. What then is the contractual relationship between the TE and the takaful fund? If you were to assume the TE is the reinsurer of the takaful fund, this would mean that the qard is actually the reinsurance claim amount. An alternative (and the one I would subscribe to) is that although the TE may be described as a reinsurer there is no transfer of risk between the TE and the takaful fund. IFRS17.B27 lists examples of items that are not insurance contracts. In particular B27 (b) states:
“contracts that have the legal form of insurance, but return all significant insurance risk to the policyholder through non- cancellable and enforceable mechanisms that adjust future payments by the policyholder to the issuer as a direct result of insured losses. For example, some financial reinsurance contracts or some group contracts return all significant insurance risk to the policyholders; such contracts are normally financial instruments or service contracts (see paragraph B28)”
While B28 states:
“An entity shall apply other applicable Standards, such as IFRS 9 and IFRS 15, to the contracts described in paragraph B27”
Based on the above extracts and, if the business model does not envisage a transfer of insurance risk from the takaful fund to the TE, it would seem that at the TE level the takaful fund should be accounted under IFRS 9.
Under this scenario where it is assumed that it is acceptable to split the takaful contract into its components we will have the relationship between the Takaful fund and the participants defined similarly as between the Mutual insurance fund and its policyholders. This means that 100% of the Expected Claims and its Risk Adjustments would remain and be accounted for exclusively within the takaful fund. The reader may then ask, “Is a Mutual insurer Sharia compliant?” The short answer is probably, “yes”, as a Mutual practices risk sharing and not risk transfer, subject however to all the business dealings and investments of the Mutual insurer being also Sharia compliant.
Finally, I want to address the issue of Solvency capital. Insurance claims, whether of an insurer or a takaful operator, are subject to volatility in claim frequency and claim severity. The level of volatility in total claims incurred depends on the risks undertaken. At one extreme you have insurance that covers, say, a nuclear accident (very low claim frequency, very high claim severity) while at the other end you have insurance that covers outpatient medical claims (high frequency and low severity). In addition to claim amount variability there are also other risks like liquidity risk, Asset Liability mismatching risk and operational risks to name a few. Under a Risk Based Capital framework, the solvency capital held is directly proportional to these risks undertaken. In takaful it is likely that, initially at least, the Solvency capital would need to be held by the Operator fund. Over time depending on how surpluses are accumulated and retained in the takaful fund, this solvency capital may eventually be held in the takaful fund itself. Some may point to the fact that Solvency capital is either partly or wholly retained in the Operator fund as proof that there is an element of risk transfer. I will answer this question with questions of my own:
- Who selects which risks to underwrite?
- Who determines the pricing of the product?
- Who manages the claims underwriting?
- Who determines the retakaful program?
- Who determines what portions of the takaful contributions are deducted as fees?
It is obvious that these decisions are undertaken by the management of the TE which acts on behalf of the shareholders. The TE not the participants effectively controls the takaful fund. This indeed exposes one of the weaknesses of the existing takaful operating model, that of the “agency conundrum”. Participants have no say in how management conducts its business of managing the takaful fund. Participants do not determine how much of the contribution actually goes to the takaful fund and how much is paid as fees to the Operator, and so on and so forth. In Malaysia the performance bonus which supplements the basic fees to the Operator, was introduced to encourage prudent management of the takaful fund. However, this concept of a performance bonus is not sharia compliant in many jurisdictions.
Given the importance of managing this conundrum, perhaps it is appropriate to allocate the regulatory Risk Based Capital required to support the business into two parts: one for the so-called Agency- related risks (which could include operational risks, Asset Liability mismatch risks, liquidity risks among others) which should always reside in the Operator fund, and the other for the remaining non- Agency related risks which should ultimately reside in the takaful fund. Subsequently, if losses in the takaful fund can be identified to have resulted from Agency-related risks, then the payment into the takaful fund would, instead of being considered a qard, be an outright compensation payment by the Operator for its operational shortfall. Such provisions do exist in the Takaful Act in Malaysia but I am not aware whether this provision has ever been triggered. Throughout my postings on applying IFRS 17 to takaful I have emphasized that accounts should always reflect the economics of the takaful contract. In this respect I believe the treatment of any qard is the cornerstone to determining whether the accounting truly reflects the economics of takaful. What I mean by this is should a qard arise the qard would not be reported as a loss at the TE level, correspondingly when the qard is repaid it should not be reported as a profit at the TE level. To do so would be accounting for risk transfer.
To summarize the points highlighted in my various postings:
- Takaful is a contract between three parties the Operator, the takaful fund and the participants. Of the three contracting parties, only the takaful fund is not a legal entity. However, IFRS CF 3.10 confirms that a reporting entity does not have to be a legal entity. Furthermore, IFRS 17 is silent and therefore does not prohibit the separation of such tri-party contracts for the purpose of accounting.
- IFRS accounting Standards are based on the “expected” model. As an example of how this can be applied is if there are two possible outcomes to an event, say whether a qard would be repaid (only the timing of the payment being uncertain) or would not be repaid (and therefore there is effectively a risk transfer) the one with the higher probability of occurring (greater than 50%) should be accounted for. Thus for example if there is a probability of only say, 5% (the actual probability would depend on the products underwritten and how professionally the takaful fund is managed) that any qard would not be repaid and correspondingly a probability of 95% that the qard would eventually be repaid means that under the expected model, accounting for takaful should assume risk sharing rather than risk transfer. Furthermore taking on a qard by itself does not disqualify the takaful fund as a Mutual insurer. Mutual insurers have also been known to take up subordinated loans from third parties. Does the presence of such loans in the accounts of the Mutual insurer imply that the issuers of such loans are co-underwriting the underlying Mutual insurance contracts? It is also pertinent to note that any qard does not necessarily have to come from the Operator; it can also be sourced from an Islamic bank (say).
- Following from (ii), IFRS17.B27 (b) gives as an example of non- insurance contracts as “contracts that have the legal form of insurance, but return all significant insurance risk to the policyholder through non-cancellable and enforceable mechanisms that adjust future payments by the policyholder to the issuer as a direct result of insured losses”. This is similar to the relationship between the TE and the takaful fund. Should the need for a qard arise the TE would provide a subordinated loan to the takaful fund. The takaful fund would repay the loan at a later date. As explained in a previous posting the uncertainty as to the timing of the repayment does not make this process insurance. Moreover, as the Operator has “control” over the takaful fund, this repayment is effectively non- cancellable and enforceable.
- The presence of statutory funds in insurance, like the presence of similar products to takaful in insurance (e.g. with-profit life insurance products) cannot be used as arguments why takaful is no different from insurance. My postings have affirmed that this comparison is invalid.
Based on the above arguments it is therefore proposed that the IFRS compliant takaful accounts should be multi-columnar and show the following:
- The first column would account for the Operator fund under IFRS 15 as an entity providing a service to the participants.
- The second column would account for the takaful fund under IFRS 17 as a Mutual entity accepting insurance risks from the participants.
- Finally, a third column at the TE level which accounts for the takaful fund under IFRS 9. This option would effectively be equivalent to applying US GAAP Deposit Accounting to takaful (see previous posting).
Takaful accounts presented in this manner would I believe, faithfully represent the economics of takaful. Importantly these accounts would be Sharia compliant.