March 14, 2016

Takaful – time for a change?

A raft of regulatory developments and a noticeable shift in market sentiment over the past 24 months will bring significant change to the takaful insurance industry in the Middle East

The tremendous growth potential of Islamic insurance has long been a talking point in the industry. Global takaful contributions are forecast to reach around $18.5b by the end of 2016, up from $12.2bn in 2013, representing a 14% annual growth rate, according to EY. Impressive numbers, especially when compared to the traditional insurance market.

However, we have started to see a shift in focus. There have been fewer headlines about future growth potential and more highlighting concerns about return on equity (RoE). In addition, recent studies suggest the sector is failing to live up to shareholder expectations and on average investors receive a lower RoE than those in traditional insurance.

It remains to be seen if this is an inherent aspect of the taka­ful structure or a reflection of the relative youth of the industry. Whether or not future growth will allow takaful operators to offset their initial start-up costs is a factor which is exerting additional pressure on the management of these operators.

What is certain is most takaful operators still suffer from a fundamental lack of scale. They comprise just 11 of the 60 insurers licensed to operate in the in the United Arab Emirates (UAE), and only 14% of the total written premium in 2014 in the UAE was sharia-compliant. These statistics are compounded when you take into account the fact a few of the larger takaful operators account for a disproportionate share of the premiums.

The outlook for the takaful industry is also clouded by the fact that the regulatory landscape in the Middle East is continuing to develop apace. Indeed, takaful operators have highlighted the need to keep up with evolving regulation as the second-greatest risk to their business after competition.

In the UAE new financial regulations became effective last year which introduced a risk-based capital model – not dissimilar to Europe’s Solvency II – which require the implementation of a raft of new systems and processes to ensure compliance. Elsewhere, in Qatar a new rule book for the insurance industry will also usher in Solvency II-style regulation, while in Saudi Arabia the market in subject to a number of a new regulations including a revised corporate governance code.

The intention of the new regulations is clear: regulators want to ensure the industry is financially strong and insurers have a clear vision of the risks to which their businesses are exposed. However, these changes will have a material impact on operating costs and one regulator – the director-general of the UAE Insurance Authority – has gone on record to say that the new rules “will eliminate insurers with small amounts of capital”.

Looking for consolidation

Although the intention may be to encourage consolidation, thereby removing the smaller players from the market, the reality may not be so simple. Historically, a number of barriers to transactions in the insurance industry in the Middle East have existed, including structural issues, mismatched price expectations between buyers and sellers and the difficulties of due diligence.

In the case of the first, the business landscape across the region is characterised by the proliferation of family businesses, many of which are large conglomerates with operations spanning a range of diverse industries. Inevitably, a level of rivalry exists, with any one family business reluctant to enter into a transaction with another that may result in conferring a potential advantage.

Should these challenges be overcome, there is also a question around the benefits of merging two sub-scale businesses that only been competing on price. Despite this, there are signs of a shift in market sentiment, which could see an increase in mergers and acquisitions involving takaful players. In two examples in the region in 2015, Bahrain Kuwait Insurance acquired its compatriot Takaful International and Dimah Capital Investment Company of Kuwait bought Bahrain’s Tazur. The likelihood is there will be more to come.

For players that do not wish to consolidate or sell part of their equity to foreign insurers, there remains the option to establish pooling arrangements with other takaful operators across the region. Such arrangements would be potentially beneficial by allowing the operators to share resources, diversify the risks to which they are exposed (through the internal reinsurance of the business written by each member) and benefit from the technical expertise of the other pool members.

There is a clear evidence such an approach can work – just look at the success Lloyd’s coverholder Cobalt Underwriting has enjoyed. Regardless of whether this becomes a feature of the market in the Middle East, it is clear there will be opportunities arising from the regulatory changes. For those prepared to adapt to them, at least.