Clyde & Co

To the casual observer the Islamic insurance market has been a series of positive stories over the last few years.  There has been an explosion in the growth of takaful operators, with a number of the major insurers entering the market, including Allianz, AIG, Munich Re and Hannover Re. Premium growth has been staggering, with some players reporting growth of fifty percent or more over the last few years.

Has the current economic climate taken the shine off these developments?  There is no doubt that the relative security of the investments used to underpin a takaful operators’ funds, which inevitably differ from those used by the conventional insurance market due to the requirements to comply with Shari’ah, has been a focus of debate in recent months.  Profit margins have been eroded as a consequence of the dependence (some would say over-dependence) on equities and real estate and the shortage of long term liquid investments. There have also been calls for renewed focus on producing technical underwriting profits.  However, there is no doubt of the potential for growth of the takaful industry with roughly 1.5 billion Muslims around the world being underserved by the insurance sector[1] coupled by the fact that many markets in which takaful would be attractive to consumers in the Muslim world have traditionally low penetration rates for insurance, takaful is rightly seen as an Islamic financial product with a bright future.

At the recent World Takaful Conference held in Dubai in April, Ernst & Young presented their report focused on the future of takaful.  It was reported that by 2012, total takaful contributions could reach US $7.7 billion[2] per year.  Even higher projected growth had previously been reported. HSBC, for example, estimated that the global takaful market to be worth US$14.4 billion by 2010[3].  The growth is spectacular when one considers that takaful contributions (premiums) were reported as being US $1.4 million per year in 2004 rising to an estimated US $ 3.4 billion in 2007, the majority of those contributions coming from within the GCC with South East Asia following behind[4].

In a sea of statistics, many of which are often contradictory, it is helpful to remember simply that global takaful contributions are less than 1% of the total insurance premium spend annually, despite the fact that Muslims are 24.79% of the total global population. Inevitably there are questions as to what proportion of this population is accessible to insurers. The fact remains that in key markets, such as the Middle East, insurance penetration remains low. It is estimated that the UAE is massively under-penetrated with insurance premiums in 2007 being reported as 56% below GDP-adjusted levels in the non-life sector and 88% in the life sector[5].

A brief history of takaful and the current position

The world’s first takaful company, the Sudanese Islamic Insurance Company was established in 1979.  Since then, to date it is reported that there are around 124 takaful companies as of January 2009 and 38 takaful windows[6] (i.e conventional insurers undertaking takaful business through a “window” which allows for safeguards and separation of contributions and assets).

At the current moment the financial crisis has severely impacted on financial institutions and this recessionary tendency has meant that growth forecasts in global markets worldwide and various sectors have been affected; major takaful markets are no exception.  The short term performance of takaful operators is reported to have been impacted.  Figures published by Ernst & Young in their latest report suggest that in taking a sample of GCC and Malaysian Takaful operators, the average return on equity in terms of percentage has dipped significantly in 2008 (especially in respect of GCC companies) and is estimated to rebound during the course of 2009[7].   However as in many other sectors, takaful operators that are able to successfully manage their business during this challenging economic environment will be well placed to take advantage of opportunities that arise when markets begin to pick up.  It is also relevant to note that negative press that certain conventional investment products have received in light of recent economic failures, and the causes behind the current economic crisis, means that takaful may also be perceived as being more attractive to consumers as it offers a more conservative method of running a risk carrying entity.

Further, takaful has broad appeal beyond the Muslim communities who are seeking a Shari’ah compliant alternative to conventional insurance and may help to unlock markets that have not historically been accessible to conventional insurers.  It can be also attractive to those who are concerned with all forms of ethical finance and finding alternatives which suit this type of ethically conscious consumer.  In addition, some non-Muslim customers may be attracted to takaful by the possibility of a return of surplus generated on the contribution they provide in order to receive insurance protection.

The future of takaful: The challenges faced by the takaful industry

As a nascent industry, there inevitably remain challenges for takaful going forward. Some potential areas which may need to be overcome in the future, if takaful is to continue to develop in accordance with the expectations that the industry has generated in the last few years, include:

Sufficient Shari’ah compliant investments?

One of the key challenges faced by takaful operators is finding suitable assets in which they can invest the revenues generated by the contributions made to the takaful pool in order to secure the ongoing nature of the business.  Since the recent economic crisis, this challenge has intensified in its scope.  The Ernst & Young report notes that this financial risk element, (including contributing factors of a restricted investment universe and unbalanced investments, high equity exposures, high counter party risk and reduced Sukuk issuance) is now the number one business risk compared to ranking as fourth last year[8]. This lack of diversification in investments limits the flexibility afforded to takaful operators to manage their investments as efficiently as possible.

The Sukuk market is a key factor.  There is a lack of liquidity in Islamic bond market and although the Sukuk market grew from US $1 billion in 2001 to US $35 billion in 2007, long term Sukuk are over subscribed and not traded frequently.  This has resulted in operators being overly dependant on regional equity and real estate markets (which has, to some extent, exposed them to the current economic crisis).  The lack of long term Sukuk is a problem which it is hoped that going forward will be addressed by other products coming to the market, such as an equivalent annuity product.

Takaful as a “young” product

Given that takaful is, compared to other financial products, in its early stages of development, this means that there inevitably remain uncertainties and divergence of opinion regarding aspects of the takaful models and the way in which business should be conducted.  These uncertainties may pose a challenge for takaful in the future to retain its credibility, especially with respect to Shari’ah compliance.

A useful analogy can be drawn with the Sukuk market after a well known Shari’ah Scholar Sheikh Muhammad Taqi Usmani, Chairman of the AAOFI Board of Scholars claimed that around 85% of Gulf Islamic bonds were not Shari’ah compliant in November 2007.  The statement had serious implications for the Sukuk market and during the next twelve months the level of activity seen was reported as being more than 50% below that of 2007[9].   No doubt this was due in part to the global economic crisis, but investor confidence, in an area driven by ethical considerations, inevitably played a part.

Takaful may also run the same risk.  It is necessary for the takaful industry to ensure that the mechanisms by which takaful works, are Shari’ah compliant in order not to lose credibility.  One example of a way in which takaful may face challenges is in respect to the doctrine of tabarru (donation) which governs the payment and receipt of contributions by participants to the takaful operator.  The exactly legal status of the contributions has not been determined.  The doctrine of tabarru is traditionally considered to make takaful contracts a form of a unilateral contract with the takaful operator i.e a donation made without expectation of any return and in turn the takaful operator also is deemed to enter into a unilateral contract with the donor to cover its risks. However, this analysis does not reflect what is happening in practice and in reality a customer who provides a contribution will do so expecting something in return, namely, the payment of claims.  Consequently many contracts issued by takaful operators appear substantially similar to those provided by their conventional counterparts and take the form of a bilateral contract.

Another example of Shari’ah risk concerns the distribution of surplus to participants. At present funds are being retained by takaful operators in order to create reserves and there are few reported examples of distributions to participants,  This return of surplus is a cornerstone of takaful and is essentially to generate a “win-win” situation in order to avoid traditional Islamic criticism of conventional insurance. However, if surplus is not returned questions arise as to what the difference is between the takaful model and conventional insurance?  Should an eminent scholar pronounce an opinion on this matter similar to that which was provided for the Sukuk market, it is easy to see that the credibility of takaful would be under threat.

Genuine Shari’ah Compliance?

The use of conventional policy wordings by takaful operators has also led to questions about the Shari’ah compliance of certain products.  Given the relative youth of the takaful industry and the comparative longevity of the conventional insurance industry, and the need to appeal to consumers who are familiar with conventional insurance products, it is perhaps understandable that insurance wordings which have been used successfully within conventional insurance market for many years, are seen as a useful template or starting point from which to develop takaful wordings.

However there are some issues with this approach and some matters that need to be carefully thought through in producing takaful policy wordings.  There are some risks that cannot be insured (new for old in home contents policies for example).  There is also a serious question as to whether certain key elements associated with conventional insurance contracts could work in a takaful context such as moral hazard, as well as an insured’s duty of disclosure and whether claims handling should be different (the use of technical defences being a particular concern).  Other relevant considerations include how remedies would work and whether there is scope for bad faith to impact within a takaful policy.  Finally it is always important to consider the impact of the interaction with local laws and regulations.

Shari’ah Scholars and qualified personnel

One common theme for the Islamic finance sector as a whole, is the need for further Shari’ah scholars to assist the growing Islamic finance and takaful industry.

It is important that there is a meeting of the minds of both Shari’ah advisors and takaful operators in relation to the nuances at play when developing a potential product, and the relevant Shari’ah considerations that would apply to such a product. A current challenge for the takaful industry to overcome is to ensure that Shari’ah scholars fully appreciate and comprehend the commercial purpose of products on offer in order to be able to advise in respect of the Shari’ah compliance aspects in a way that both allows takaful operators to undertake their business with certainty, and ensures the Shari’ah compliance and credibility of the product. The chronic shortfall of scholars for the Islamic finance industry as a whole, is compounded in takaful, where there are few scholars with any genuine depth of understanding of the insurance market.

In addition another perennial problem faced by the Islamic finance industry as a whole is the lack of qualified staff and sales people who actually appreciate and understand the product sufficiently to explain the product to consumers (to whom the concepts are likely to be new). It is hoped that in the future that as the Islamic finance industry as a whole, including takaful, grows, this problem may be alleviated with further experience being accumulated within the market.

Both the lack of scholars and qualified personnel can only be resolved by the takaful industry investing in people. As the size and number of takaful operations grows, it is to be hoped that this issue will fall away.

Incentivising consumers and providing products which are relevant to the consumer’s demographic

Another challenge which is important for the takaful industry to overcome is reaching out its consumers in providing products that are relevant and appealing to the consumer market.  The countries targeted for takaful growth are based mainly within the Muslim world, where insurance penetration rates are traditionally low, particularly in respect of life insurance. Traditionally there has not been a culture of incentivising consumers by providing, say tax breaks, or encouraging private sector savings as may be found in Western countries.  Further, in contrast to the aging populations of the West where the focus may be in providing adequately for retirement, the demographic within Muslim countries, and especially the Middle East, is a youthful population.  The challenge will be to ensure that takaful products appeal to this new generation and appear relevant to them.

Family takaful (or the takaful equivalent of life insurance) is a particular area in which further growth is expected as it currently remains underdeveloped.  The possibility of developing Microtakaful (which would provide insurance coverage for low income individuals with the idea of making cheaper risk coverage affordable for a much wider audience) is widely speculated as providing another opportunity for great growth in developing markets as a more economical alternative to mainstream takaful.

Distribution channels?

One final challenge to highlight is that there will need to be a development of distribution channels, particularly if takaful industry is to succeed in penetrating into personal lines such as family takaful.  Internet sales and bancassurance (or bancatakaful) are likely to become of increasing importance to the industry in the coming years. Bancassurance in particular is widely recognised as an important platform for takaful operators to reach out to potential consumers through their chosen banking provider. However, both internet sales and bancassurance generally currently faces some regulatory hurdles and lack of regulation in the GCC is a major issue.  There remains in the United Arab Emirates, considerable uncertainty as to the validity of bancassurance in strict keeping with the current insurance legislation and legislative reform is required if the necessary protections for consumers and the industry’s need for certainty are to be resolved.

Conclusion

Despite the challenges that have been highlighted in this article, there is certainly great cause to be optimistic regarding the future of takaful and its huge potential for growth.  In the Middle East as a whole, the current level of GDP per capita is not currently reflected in the insurance penetration rates.  As highlighted above, life insurance remains particularly undeveloped and the opportunity for family takaful to step into this role is extremely viable.

Despite the challenges facing the takaful industry, there is no reason why it should not succeed to be the future means by which many more Muslims and non-Muslims around the world seek to protect their lives, health, possessions and businesses.

Peter Hodgins and Caroline Jaffer are part of Clyde & Co LLP's Middle East Regional Office, Insurance and Reinsurance team, based in Dubai.

Published on 08 August 2009 | Jurisdiction: Middle East Areas of expertise: Insurance and reinsurance