The takaful sector in Malaysia has benefited from having to operate under a separate regulatory framework from conventional insurance, supported by a government with an agenda to make Islamic finance a success, says Ms Aiza Yasmin Benyamin of Actuarial Partners Consulting.
Given the understanding that takaful is just insurance, albeit ‘Islamic’ insurance, most would not understand the need for a separate regulatory framework for takaful. In fact, in most countries, takaful operates under a conventional insurance regulatory framework. However, it is important to understand that takaful is not insurance. The underlying risk pooling feature of takaful, where risk is not transferred to a separate corporate entity, but pooled among takaful participants is more akin to a mutual. Takaful principles also imply that the takaful operator is also not compelled to guarantee payment of claims if the risk fund’s assets are insufficient to meet the ongoing claims, ie, the benefit payments are not guaranteed.
In reality, consumers do not appreciate the fundamental difference – they purchase products such as motor takaful and mortgage takaful expecting the cover to be identical to insurance. Hence, the regulator in Malaysia, while taking cognizance of the fundamental differences with insurance applies a separate regulatory framework to takaful operators primarily to protect participants’ interest.
Before we delve deeper into regulations, Malaysia’s success story in developing takaful can be narrowed down to these main factors:
- A supportive government – as evident in the development of takaful specific regulations;
- A strong Islamic finance environment – this provides the ease of investing in shariah-compliant assets; and
- A ready market of Muslim consumers (65% of the population are Muslim).
However, in an attempt to ensure a ‘level playing field’ between insurance and takaful, several unsavoury developments have turned up in the market, such as:
- Similar takaful product design to insurance: From a consumer viewpoint, apart from shariah compliance, there is no clear differentiation in the two concepts. This is fine for products which satisfy a particular need such as motor takaful, but there are other market segments where the unique selling proposition of takaful can be used for differentiation.
- Sales are driven by price competition especially on commoditized product (motor, MRTT): Although fundamentally the underlying protection principles are different, and surplus share via a partial refund of premium is a feature of takaful policies in Malaysia, on the outset, consumers still compare prices between takaful and conventional insurance in their purchase consideration.
- Evident stress to achieve a good return on capital: When compared to insurers, takaful operators struggle to provide ‘acceptable’ returns as similar capital requirement is levied although takaful operators do not take all the surplus/profits from insurance activities.
Let us go into the details of the regulatory framework in Malaysia to elucidate the points made above. Largely the main regulations governing takaful in Malaysia can be broken down into three: the Islamic Financial Services Act (IFSA) governing all Islamic financial institutions (IFIs), Risk Based Capital Framework for Takaful (RBCT) setting out capital and solvency requirements for takaful operators, and the Takaful Operators Framework (TOF) which serves to provide a guidance on acceptable operational practices. Other regulations are also in effect – these can be found on the Bank Negara Malaysia (BNM) website.
There are of course similarities between the legal and regulatory framework governing both insurance and takaful. They cover regulations around the management of insurers and takaful operators, including the conflict of interests, and corporate governance. However, for takaful, there is an additional overlay – takaful operators are further subject to a shariah governance framework. Importantly, this framework seeks to set out requirements for investment to be shariah-compliant and the segregation of funds between participants and the operator. The segregation of funds here does not stop at physical separation, but also ownership of the funds itself, the participants’ funds and the operator’s fund.
Shariah governance framework within the IFSA
IFIs in Malaysia operate under a shariah governance framework which is comprehensive and covers business operations and documentations, including contracts, agreements, and even brochures.
The Islamic Financial Services Act, 2013 (IFSA) is similar to the Financial Services Act (FSA) which governs conventional financial institutions in Malaysia, but with an additional focus of compliance with Islamic rules and principles. The shariah governance framework governs the company practice, covers stakeholders’ scope of duties and responsibilities and further, provides details on processes and procedures in the operations of IFIs with the aim of observing shariah compliance. This is achieved by having an additional layer of governance in the forms of a Shariah Advisory Council (SAC). The SAC acts as a religious supervisory council, whose members comprise a majority of Muslim religious scholars in the country, to advise the takaful operator on the operations of its takaful business in order to ensure that the business does not involve any element which is against Islamic teachings. For takaful, this extends to investments and business ethics to product development and sales documentations. As the regulator, BNM also has an SAC which has the ultimate power in deciding compliance should there be differences in opinion among shariah scholars in the country. Bank Negara’s SAC is the highest shariah authority in Islamic finance in Malaysia.
Risk-based capital framework and the distinction for takaful
The supervisory capital adequacy ratio (CAR) for Malaysia is set at 130%, with many takaful operators demonstrating a much higher capital ratio – most even beyond the internal target capital level set by the company. The CAR is tracked closely and reported monthly with any sudden change drawing much interest from the regulators.
The CAR is computed by a ratio of total capital available to capital required. In recognising the total capital required, the asset-related market and credit risk charges, and liability-related charges reflect the associated risk and are set similar to conventional players. However, one distinction is that the expense risk charge and the operating risk charge needs to be met solely by the shareholder’s fund to reflect where these risks reside.
Another major distinction is that, while capital resources from the shareholders’ fund are fully available, for each takaful fund, capital resources are only recognised up to the amount of supervisory capital required for the said fund. ‘Excess’ surplus within the risk fund is not recognised as capital. This has been done to avoid cross-subsidies firstly between takaful funds, recognising the segregated ownership of each takaful fund, and secondly recognising the segregation of ownership between participants and shareholders. Hence, smaller funds or funds with more volatility cannot rely on the support of other risk funds. Capital to meet this liability will need to be built up within the fund or be met by shareholders.
The limitation on recognising capital within the risk fund to TCR is not as straightforward when we consider the internal CAR target (ITCL). If, for example, this ITCL is 150%, but since capital recognised from the risk fund is only up to 130%, although there may exist a further surplus within the fund, there is an immediate formula-driven capital deficit which would need to be borne by shareholders. The excess surplus in the risk fund above 130% does not flow into the computation. The intention of course is to encourage this ‘excess’ surplus to be distributed back to participants rather than held back in the fund. Hence, in practice, many risk funds hold a slight buffer above the supervisory capital, but not much else.
Further for takaful, there is a qard (loan) facility extended by shareholders to risk fund(s) to meet deficits within the risk fund and which is payable from future surplus of the risk fund. Qard can be recognised as Tier 2 capital, similar to subordinated debts. However, within the shareholders fund, qard to the takaful fund needs to be deducted in calculating capital available.
Finally, in terms of computing regulatory reserves, one issue that impacts takaful operators which have not yet reached critical size is the implicit requirement in valuation of liabilities that expect future expense overruns on maintenance expenses to be capitalised. New setups and smaller players which have yet to reach critical size may face difficulties financing future expense liability upfront. Given that the statutory valuation covers only the in-force block, we find takaful operators being vigilant in assessing the appropriateness of the expense allocation between new and existing business. There may be an inclination to allocate more expense towards new business to avoid a hefty expense liability. An expense study is normally performed periodically to justify the renewal related expense assumptions.
Takaful operating framework governing surplus distribution
The TOF issued by BNM in June 2019 heralded a new environment of a more definitive description of parameters that govern operational requirements of a takaful operator.
Surplus distribution is one of the specific issues the TOF addresses. In most takaful contracts in Malaysia, there is a mechanism to refund surplus back to participants, either on an annual basis or accumulated to maturity (the latter to ride out volatilities over the certificate term). How operators define the surplus is important as this has an impact on the surplus distribution policy. Currently, most policy contracts are vague when referring to ‘profits’ to be shared with participants, but a few make reference to the need to first meet reserving and solvency requirement before any surplus is distributed.
As an example, when actuarial liabilities are valued on a best estimate basis and taking into account only guaranteed benefits a surplus would normally arise. This surplus is the capitalisation of the margins, contingency and profit loadings in the pricing basis over the full duration of the policy. Thus how the actuarial liabilities are calculated will determine what surplus will emerge during a valuation. The differences in approaches of calculating the actuarial liabilities would then determine the extent we delay the emergence of surplus to participants and importantly, which generation of participants will receive the surplus declaration (Figure 1).
Under the TOF, there is now a requirement to document the company’s surplus distribution policy. The policy should also be shared with the regulators. The TOF requires that surplus distribution for the year be recommended by the appointed actuary and endorsed by the board. Primarily, notwithstanding the points made earlier on determination of the capital available, the appointed actuary will need to consider the long-term viability of the risk fund before releasing any surplus. There is a new draft TOF which fine-tunes these requirements and also provides the ability to innovate into differing product designs not yet seen in Malaysia.
Outcome and future development
The evolution of the takaful industry in recent years has been closely aligned with the need to conform to regulatory guidelines issued by BNM. Undoubtedly, takaful has thrived in Malaysia supported by a government with an agenda to make Islamic finance a success.
One criticism levied is the strong focus of the regulator to create a level playing field which implies creating a one-size- fits-all solution. Unlike conventional insurers where there is a clear risk transfer – the policyholder passes risk on to the insurer in exchange of an insurance premium – we have to remember the core principle of takaful is that of risk pooling among participants, which implies being a takaful participant is more akin to being a member of a protection club similar to the protection & indemnity (P&I) club in marine insurance. The current set of regulations do not take cognizance of this – often implicitly passing on rules that hold the takaful operator ultimately responsible for any losses, and hence requiring capital to demonstrate the financial strength of supporting an insurance business, rather than as an operator/administrator.
However, admittedly regulations are not the sole challenge for takaful to thrive. In Malaysia, the main challenge remains the low awareness of the concept of financial protection among Muslims, who make up the bulk of Malaysia’s population. BNM has done a stellar job in keeping the Islamic finance agenda in the minds of the population as evident in the success of Islamic banking and the growing acceptance of takaful reflects the increasing familiarity with the takaful concept among Malaysians. It is now time to ensure takaful plays its role in supporting a higher insurance penetration in the country. Arguably, takaful is also a natural market for the underserved market segments – to capitalise on this and for takaful to innovate into new market segments such as the mass market (the lower income or lowest 40% of wage earners, B40), new regulatory options will be needed. One exciting development has been the FinTech regulatory sandbox framework and we look forward to further innovative regulatory development.