Bank Negara Malaysia’s guidance issued in its Takaful Operational Framework (TOF) is the strongest pronouncement thus far by a regulator on using retakaful facility over conventional reinsurance. Mr Hassan Scott Odierno of Actuarial Partners discusses the operational differences in the workings of retakaful and reinsurance, and how this can be made clearer.
Tucked away in the Bank Negara Malaysia’s new Takaful Operating Framework (TOF) is a section guiding takaful operators on the placement of retakaful cover. In particular, it mentions:
- Takaful operators shall ensure that risks are ceded to takaful operators or retakaful operators unless there is no available cover offered by a takaful operator or retakaful for a particular risk.
- Takaful operators shall not accept inwards reinsurance or retakaful from insurance or reinsurance companies.
Items 1 and 2 effectively serve to separate takaful risks from non-takaful risks at the retakaful/ reinsurance level. With the increasing number of retakaful operators, there is now no reason not to use a retakaful provider when ceding risks from the takaful pool.
How is retakaful different?
Shariah’s concern with reinsurance has to do with:
- The lack of transparency. A fundamental principle governing commercial transactions in fiqh muamalat (Shariah law governing commercial transactions) is the need for transparency. In many reinsurance contracts, how much of the premium goes towards the reinsurer’s own expenses, how much is used to pay claims, and ultimately what surplus arises at the end of the contract term, are usually not disclosed to the cedant. A Shariah-compliant contract needs to be transparent to the transacting parties.
- The presence of speculative risk in the transaction. One of the prohibitions of Shariah-approved contracts is the presence of speculative risk. Given that the reinsurer stands to make either a gain (when premiums exceed claims) or a loss (when claims exceed premiums), depending on the happening or not of a contingent event and the resulting claim, speculative risk is present in the reinsurance contract.
- The presence of interest-bearing investments in the reinsurance fund. The use of reinsurance premium (and capital of the reinsurer) to invest in interest-bearing securities which are prohibited investments under Shariah law makes reinsurance unacceptable.
Pooling of retakaful risks is pool to pool, not business to business
Perhaps more important is the difference in the nature of retakaful as compared to reinsurance. When a reinsurer takes on the reinsurance premium, the contingent liability is transferred to its (shareholders’) balance sheet. This contingent risk had initially resided in the insurer’s balance sheet. The reinsurance company through the reinsurance contract is affording protection to the direct insurer’s balance sheet. Effectively the transaction is one of business to business.
Risks under takaful remain within the takaful pool. Effectively, the takaful participants share any losses arising from an insured event among themselves. This risk sharing is necessary to avoid the Shariah prohibition against commercial transactions which involves speculative risk. Under this scenario, the takaful operator has no “insurable interest” as losses are for the account of the participants. The takaful operator is an agent of the participants and places retakaful on their behalf.
The retakaful operator, on its part, creates a “super takaful pool” where risks from many “takaful pools” are aggregated allowing for a spread. This allows bigger risks to be pooled more effectively, resulting in an expected claims experience which is relatively stable, and thus lessening the need for speculative capital.
Pooling of risks required across different risk pools
Pooling of risks allows the law of large numbers to provide predictability to claims payable. However, in many instances, the pooling available at the takaful company level is too small to allow the predictive effect to manifest itself. If we consider the nature of insured claims, the stability of claims is subject to the expected number and range of claims severity. In a practical sense, it is not the number of insureds that drives stability but the number of expected claims.
You can have 10,000 policies but if the number of expected claim is say 10 in a year, even one additional claim will result is a 10% deviation from expected.
Pooling can also be done across time periods, not just across a group of risks. The claims experience can be less volatile, taken as an average over any 10 years than over any one year. In the example above if, instead of one year, events are pooled over 10 years, then the number of expected events (claims) rises to 100. And if there were to be an additional one claim over the period, this is a 1% deviation from expected rather than a 10% deviation.
Pooling can be across geographies; a drought affecting agriculture in one country can be offset against a year of plenty in another part of the world. This requires a global approach to the “pricing”.
One perceived impediment to pooling of risks is the concern that the participants in a pool would abandon the pool should it register a loss. This could arise due to either an expectation of a share of a smaller surplus, if any, arising in the pool and/ or the expectation that rates would increase due to the pool’s adverse claims experience.
A relevant question to ask then is whether there really is a group of participants who will remain in the participants’ risk pool even if it is in deficit? The concept of funding deficits in the risk pool through loans (Qard) from the retakaful operator which then has a first claim on any future surplus to repay the loan may mean that no surplus sharing may be expected for several years if the participants renew its participation in the current pool. Indeed, in the face of a deficit, the participant choosing to remain in the pool would only do so on the basis of solidarity with all who are in the pool.
How should the takaful operator choose?
In return for the wakala fees the operator has received, the operator is obligated to protect the risk pool against unplanned volatility; this requires retakaful, not reinsurance, so as to preserve the Shariah compliance of the originating contract. His choice of retakaful provider should be driven by an assessment of the ability of the provider to offer the type of cover and services required of the takaful pool and at reasonable cost. Choice is therefore not driven by the cost factor alone.
More pertinently, the operator’s choice of provider should not be dependent on the retakaful brokerage that the operator gets from the provider (this “retakaful brokerage” needs to be distinguished from the commission the takaful pool gets from the provider, as such commission goes to reduce the cost of the retakaful cover to the pool). Ethically, there is a case to be made that the operator should not receive any brokerage from the provider as this can be interpreted as an inducement not to act in the best interest of the takaful pool.
The choice of basis of retakaful should not also affect the operator’s contract with the participant. For example, a quota share retakaful arrangement on original contribution basis (which splits the risk from the first ringgit) would infer that the operator has “contracted out” a part of the contract with the participant without the knowledge or consent of the participant. This is because such “contracting out” usually affects the ultimate benefits of (and/or risks carried by) the participants in one way or another as the benefits are variable.
The role of retakaful is to expand the pooling across other similar takaful pools and across takaful pools in other geographies. The argument put forward by some takaful operators not to pool with other cedants is loss-of-surplus- share on their portfolio. As long as the contribution rate to the retakaful pool is determined at best estimate for the risk underwritten, the issue of unfair sharing of surplus should not arise.
Retakaful is not reinsurance
It is apparent that the confusion in the marketplace between retakaful and reinsurance has to do with the way retakaful has been executed to date. Both the takaful operators and retakaful providers have to shoulder the blame for perpetuating this confusion, the former for insisting that the providers maintain a separate pool for their risks and the latter for not communicating clearly why a separate pool is not considered pooling, and the other various differences between reinsurance and retakaful.
To summarise the reasons why retakaful is different from reinsurance:
- Executed properly, retakaful pools risks, rather than transfers risks.
- Retakaful pools risks for the participants. Unlike reinsurance where the insurer is protecting the shareholders account from losses due to claims volatility, the operator has no “insurable interest” as losses are for the account of the participants.
- Retakaful providers do not pay brokerage to operators.
- Retakaful investments are Shariah-compliant.
There is no issue that, with the availability of capacity in the retakaful market now, the takaful operator should use retakaful. This is the participants’ decision, not a decision the operator has to make. Retakaful providers should make the effort to differentiate themselves much more clearly from reinsurance providers. Thus, there should be pooling with other cedants and the pooling should be modelled so as to be equitable among cedants. There should be an effort to reduce the volatility of claims so as to minimise the need for a Qard.
There should be no brokerage paid to takaful operators. The operator’s client is the participant. For corporate governance to work there can only be one client and the interest of the agent (the takaful operator) should be fully aligned with that of his principal (the participants).
Finally, it is crucial for the development of retakaful for pooling to spread across geographies; this is the only way to reduce reliance on speculative capital. Bank Negara’s requirement that takaful operators use retakaful exclusively is both insightful and welcome for the continuing development of the takaful industry in Malaysia.