ACCOUNTING TREATMENT

AND ISSUES IN TAKAFUL

ACCOUNTING

TAKAFUL

Process of communicating financial information about a business entity to users such

as shareholders and managers

It is basically the recording and

presentation of economic transactions to defined business operations, usually a legal entity

Mutual cooperation which it has become

synonymous with Islamic Insurance

NATURE OF TAKAFUL

In terms of detailed accounting, is largely similar to that of conventional insurance operations. Both receive contributions, investment income, pay claims, maintain reserves, and have assets and liabilities DIFFERENCES • The method used to remunerate the Takaful operator

• The nature of mitigating risks (re-takaful vs reinsurance)

• The nature of investments, which, by their very nature, excludes fixed income investments.

Malaysian Takaful Accounting & Reporting Regulations

The accounting and reporting for Takaful has not been covered by FRSi and is still being developed. As an alternative, the Malaysian Government through its specific Takaful Act (1984) delegated the function of formulating the accounting techniques, format and contents of accounting disclosure of Takaful companies to the Central Bank (BNM)

Takaful operators are also presented with Shari’ah based, non-legal backed accounting and reporting standards produced by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). These standards however, have never been enforced on operators for their adoption by BNM but it did indirectly allowed operators to adopt AAOIFI standards on a voluntary basis.

Given similarities with conventional insurance with respect to most economic transactions, therefore accounting methods for these transactions should be similar. It is not necessary to define all-encompassing accounting standards for takaful operators separately (as has been done by the AAOIFI), but instead to deal with issues where the nature of takaful operations is different from conventional insurance

There are 3 models of takaful been implemented:

•  Mudharabah model •  Wakala model •  Waqf

However, the accounting issues are common

ACCOUNTING ISSUES 1.  Segregation of assets, liabilities, income and expenditure 2.  Reserves 3.  Revenue and expenditure recognition

4.  Qard-e-hasn

1. SEGREGATION OF ASSETS, LIABILITIES, INCOME AND EXPENDITURE •  Determine the surplus or deficit which would impact the

distribution to participants •  Determine the solvency position of the takaful fund,qard-e

hasana or repayment •  Income=assets

•  expenditure=liabilities

•  Contributions,claims= takaful funds

•  Bank charges, investment=equity

2. RESERVES Takaful operator need to set up the reserves consist of:  Unearned revenue reserves

-Tabarru which is received for periods which extend beyond the financial reporting date

 Claims

- claims incurred before the reporting date - claims which have been reported or not

 Deficiency reserves -expecting contributions charged are not adequate to cover expected claims

 Contingency reserves

- set aside proportion of claims which will be made in the future

3. REVENUE AND EXPENDITURE RECOGNITION •  Cash vs accrual •  takaful organizations recommend the recognition of

revenues under cash basis •  surpluses determined based on “actual” and not

“accrued” revenue •  Shubber and alzafri: deposit accounts+liability and equity

because of hybrid source of capital

•  Muhammad (2002): Revenues on investment=income

•  He also highlights the treatment of cash and accrual basis in takaful

•  Takaful only applyling cash basis due to gharar exist in the creation of unearned revenue

•  Qard-e-Hasana, in a Takaful concept, is a loan made to the takaful fund in order to cover a deficit in that fund after exhausting any contingency reserves.

•  While discussing the accounting treatment of amounts so transferred, both in the period of transfer as well as amounts due, at the balance sheet date, from the takaful fund to the takaful operator, one can draw a parallel with capital contributions from the shareholders’ fund to a statutory fund which is describe under the Insurance Ordinance 2000.

•  It is not appropriate to treat the amount outstanding as a liability of the takaful fund and an asset of the takaful operator.

4. ACCOUNTING FOR QARD HASANA

•  A pooling risk mechanism •  The takaful operator has to share any surplus or deficit arising in

the pool •  Widening the spectrum of the principle of solidarity or mutual help

•  Without retakaful, takaful operator has limited implementation of principle of tabarru’ within the boundary of single takaful pool

ACCOUNTING FOR RETAKAFUL

•  Takaful operator has extended a qard ul-hasan to the retakaful pool

•  The qard has to be set aside separately by letting go the takaful funds, and it is going to be earned back from future surpluses

•  Follows the same principle in other Islamic financial institutions

•  Recognition of dividends declared on equity investments •  Recognition of unrealized capital gains

•  When a single participant exits, another single participant must replace and enter at the same time

ACCOUNTING FOR REINVESTMENT

•  Dividends from ordinary shares that have become ex-dividend before balance sheet date is recognized as accrued investment income

•  Investment must be noticeable for the purpose of computing capital gain

•  Make sure investment activities are compliance with Shariah

•  Consider participants’ expectation on investment strategy for takaful fund

TREATMENT OF SURPLUS Surplus in life insurance •  In conventional insurance, the surplus from the

investments is transferred to shareholders as income. •  but in the family takaful (life), the company is not entitled

to recognize this as a revenue surplus. •  In family takaful, only income from investment funds will

be distributed among the participants and the company according to the agreement ratios (eg 70:30 or 60:40).

•  Net profits for the company, the rest of this profit is revenue for the takaful participants are credited to the account of participants.

Surplus in general insurance

•  Profit from the general takaful (losses) are distributed based on the profit sharing ratio agreed upon between the companies and takaful participants.

•  Benefits paid if the participant is still bound by the agreement or takaful contract.

•  If the loss occurs in the general takaful, the participants come to bear, together with other participants.

•  This is based on the principle of al-Mudaraba where Shahibul-mal (owner of the funds) will bear any losses that occur, in this case is the participant.

DIFFERENCES BETWEEN CONVENTIONAL INSURANCE ACCOUNTING AND TAKAFUL ACCOUNTING

NO CONVENTIONAL INSURANCE TAKAFUL 1 Insurance premiums are

recognized as revenue even though the insurance premium is not paid

Insurance premium is actually recognized as income when received in cash

2 Retakaful expense over the initial agreement recognized as a covered insurance.

Retakaful expense recognized as a debt to be paid installments or takaful premiums. And expenses are recognized as revenue retakaful if paid in advance.

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3 Insurance funds collected are managed for the benefit of business profits enjoyed by the company and shareholders

Cumulative takaful insurance funds are managed by the concept of mudharabah

4 Profit or surplus from the investments is transferred to shareholders.

Investment earnings from family takaful funds are distributed to the participants and takaful companies are not entitled to recognize this as a revenue surplus.

5 The advantage gained by the insurance company is a profit to the company

There is profit sharing based on the ratio agreed in the contract.

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ISSUES OF IFRS WHY CURRENT APPLICATION OF IFRS IS PROBLEMATIC

FOR TAKAFUL BUSINESSES

•  With significant growth outside their current major markets of the Middle East and Malaysia, a large number of Takaful businesses are reporting under International Financial Reporting Standards (IFRS)

•  Despite these key conceptual differences, regulations in many jurisdictions treat Takaful operators exactly the same as conventional insurance companies.

•  This gives rise to accounting and reporting treatments under IFRS which can be at best a poor fit, and at worst fundamentally unsuitable to reflect Takaful principles.

For example: •  Definitions under IFRS relating to insurance contracts and

insurers do not reflect the risk sharing nature of Takaful contracts: IFRS assume a transfer of risk.

•  In order to present comparable financial information, IFRS largely ignores actual Takaful structures.

•  Contributions from participants are treated as revenue, when it would be more accurate to record them as liabilities.

•  Claims and other expenditure paid out of Takaful funds are recorded as expenses, when in fact they are a reduction of liability.

•  Some Sharia scholars argue that funds received by Takaful operators are fiduciary in nature and therefore should not even be shown on the operator’s balance sheet.

•  The IFRS accounting treatment of agency fees earned by the Takaful operator and charged to the fund can result in a confusing mismatch within the financial statement.

•  This is because fees are deferred in the Takaful fund as an acquisition cost, but recognized upfront in the operator’s income statement as service revenue.