Takaful Regulations: Implications of new financial reporting, Government Services Tax and Basel II...

8/8/2019 Takaful Regulations: Implications of new financial reporting, Government Services Tax and Basel II Requirements o

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Takaful Regulations: Implications of new financial reporting, Government Services Tax andBasel II Requirements on Risk Base Capital

Azah Atikah Binti Anwar Batcha

Abstract

Islamic insurance, also known as Takaful, is the means of bringing both social andeconomic benefits of modern insurance coverage, in a form which is consistent with religiousbeliefs, to Muslims and to the emerging economies of many predominantly Muslim countries.

Therefore, the development of Takaful is crucial, and to economic development in a number ofcountries with emerging market economies. It is therefore hardly surprising that the Takaful

industry is undergoing a period of rapid growth. However, the development of Takaful in stillfacing formidable barriers that are largely due to the complex structure of Takaful undertakings

and the unresolved issues associated with it. These issues contribute to making the developmentof an appropriate legal and regulatory infrastructure, as well as disclosure, financial reporting,corporate governance, and Basel II requirements on Risk Base Capital as well as other related

matter, made it less problematic for the Takaful industry, we hope. It is still long way to go for

Takaful to be completely free from all the issues involved in its current practice. Thus, a hightransparency and disclosure regulated framework is needed in order to cater the industry.


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1.0 Introduction

It is a natural fact in any society that everybody is exposed to all sorts of unexpected risks in his

daily life. These risks may occur to ones life, property or even business ventures. The main

question which we should ask ourselves is that how do we prevent or help ourselves in such

unfortunate events? One method in doing so is by practicing or applying concept of insurance.

The main objective of insurance is to uphold, among parties involved, shared-responsibilities on

the basis of mutual cooperation in protecting an individual against unexpected risks.

In addition to the need for raising the level of consumption of basic amenities in life, individuals

need adequate and stable income from wage or self-employment, legal protection of their right to

livelihood in the informal sector, and protection against natural disasters or social disruption

(Getubig & Schmidt, 1992). They also need old age and child care, problems that have become

more acute (Getubig & Schmidt, 1992).

However, in this paper, we shall discuss about the concept of Islamic insurance, which is also

known as Takaful. We shall also discuss its current regulations and disclosure requirements and

the impact of new financial reporting, introduction of Government Services Tax and the Basel II

requirements on Risk Base Capital as to current Takaful practices.

1.1General Concept of TakafulIslam establishes permissibility rule which is not unallowable (haram) except where it is

prohibited by a sound and explicit rule from Quran or clear, authentic, and explicit

Sunnah (practice or saying) of Prophet Muhammad S.A.W when it comes to business

relationship among people (Iqbal, 2005). This applies to the concept of Insurance.

A Shariah- based insurance policy would never involve the unlawful elements1. In fact, it

would be based on al-Mudarabah (profit and loss sharing financing technique). In this

dealing, the participant pays contribution to the Takaful operator who runs a business

with the accumulated money. Then, the profits earned from such transaction shall be

shared by both the participant and operator accordingly (Billah M. M., 2003).

1This elements includes Riba (interest), Maisir (gambling) and Gharar (uncertainty)


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According to Billah (2003), an Islamic model of life insurance, the nominee is not an

absolute beneficiary but a mere trustee who is under who is under an obligation to receive

the benefits from the policy and distribute them accordingly among the legal heirs of the

deceased in accordance with the principles of al-Mirath2

and al-Wasiyah3.

Covering ourselves in the event of our death could benefit our loved ones and our estate.

However, depending on our policy, our benefits will vary from covering funeral costs and

medical bills to paying any outstanding debts (Razak, 2009).

1.2What is Takaful?Takaful is widely known from an Arabic word which means guaranteeing each other.

Takaful is an Islamic insurance which are basically based from the concept of taawun4

and tabarru 5 whereby the risk that associated with it is shared among a group of people

voluntarily (Ismail & Abdul Razak, 2010).

The Takaful Act which was introduced by the Malaysian Government in year 1984 was

enacted in order to provide for registration and regulation of Takaful businesses in

Malaysia and for other purposes relating to or connected to Takaful. In addition, as

recalled above, Takaful is a term used to describe insurance schemes which are Shariah-

compliant (Venardos, 2006).

In Section 2 of the Takaful Act 1984, Takaful has been defined as a scheme which is

based from brotherhood, solidarity and mutual assistance which provides for mutual

financial aid and assistance to the participants in case of need whereby the participants

mutually agree for the purpose (BNM, 2010).

Currently in Malaysia, Takaful is being practiced not by insurance agents or brokers, but

directly by S yarikat Takaful Malaysia6

through the desks of Bank Islam Malaysia

branches and sixteen Tabung Haji7offices (Venardos, 2006).

2An Arabic term which refers to what we called in English: Inheritance

3An Arabic term which denotes a Bequest

4It means Mutual assistance

5Gift, donation

6First established Takaful company in Malaysia

7Tabung Haji is the Malaysian hajj pilgrims fund board


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There are many reasons affecting the need of Takaful and Insurance according to Razak,

(2009), such as:

(a) Income-replacement needs

(b)Final-expense needs

(c)Readjustment-period needs

(d)Debt-repayment needs

(e)College-expense needs

(f) Government Benefits

(g)Existing Insurance and Assets

According to Venardos (2006), in Malaysia, there are two forms of Takaful insurance

which are explained below:

(i) General Takaful InsuranceThe types cover offered are fire, motor, accident, marine, personal accident,

workers compensation and employers liability. The participant determines the

amount for which he wishes to insure, and pays his Takaful contribution to the

company. The amount of contribution is assessed on the value of the asset to be

covered. The contract runs for one year and specifies that any profit will be shared

in a given ratio if the participant does not make any claims. The company pools

all contributions and invests them in halah investments. The participants agree

that the company shall pay compensation from the general fund to any fellow

participant who might suffer a loss, and also operational costs.

(ii) Family TakafulThis is an investment programme

8to provide halah investment returns to the

participant as well as mutual financial aid. Individuals participate to saveregularly a sum of money to provide for dependants if they should die

prematurely, or as a contingency savings if they survive to maturity of the plan.

8This is based on Mudarabah Principle. It is a partnership where one partner gives money to another to invest in a

commercial enterprise (the rabb-ul-mal), whilst the management and work is the exclusive responsibility of the

other (the mudarib).


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The plan may be taken for terms of ten, fifteen or twenty years. Participants must

be between the ages of eighteen and fifty years, and the plan must mature before

the participant reaches sixty years.

1.3Role of Takaful Operators/Agencies in Islamic Financial InstitutionsThe Ultimate Aim of the Takaful Agency Members

9is to seek the pleasure of Allah Most Exalt,

submit entirely to His Will and strive for the final abode in the Hereafter.

All Takaful Agents act as Businessman or Businesswoman. Therefore, as quoted from Al-

Qadarawi10

who said:

Any merchant who remains within the bounds of honesty and fair dealing in such an

atmosphere is a fighter against his desires, meriting the status of a warrior in the cause of

Allah.

Takaful Operators takes on the task of Recruiting, Training, and retaining the agencies. This is

by no means is an easy task (Yap, 2009). It is also mentioned by the author about the various

briefs of the Organizations and Functions of the Takaful Agency.

(a)Takaful Agency Manager11

Overall expansion of the Takaful agencys business

Plays a strategic role for profitability of his agency

Overall responsibility to the development of his agency

Markets and sells the Takaful plans

Develops a huge customer and client base

Services this client base

Develops and build up specific markets

Recruits train and motivate Takaful Agents

Takes on a leadership role for the Industry

9The range starts from Agency Manager, Unit Manager, Specialist and Agents.

10Sheikh Yusof Al-Qadarawi is a public intellectual and immense international influence.

11This is also known as Group General Manager.


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(b)Takaful Unit Manager12




Develops and build up specific market

Recruits, train and motivate Takaful agents

Takes on a leadership role for the Industry

(c)Takaful Specialist13




Specializes in certain Takaful markets

(d)Takaful Agent14




The actions, behaviors and attitude of the Takaful Agent also matters. The Agency Manager,

Unit Manager, Takaful Specialist and Takaful Agent together they form an organization. Each

has their special and unique task and contribution (Yap, 2009). They should work in unison

towards the economic success of both the agency and their respective family (Yap, 2009).

12Also known as Agency Manager.

13Also known as Charted Takaful Underwriter.

14Acts as Consultant.


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1.4Sources of Law Affecting TakafulAn insurance policy remains valid if none of its aspects contravene the Shariah principles.

Hence, every element of an Islamic insurance policy should absolutely be based from the

Shariah. The sources of law affecting Takaful can be gained from the Holy Quran, Traditions of

the Prophet (s.a.w)15

, Analogical sources16

, as well as its Principles of Contract (Billah M. M.,

2001).

1.4.1 The Holy Quran

The Holy Quran and the Sunnah contemplate one community of faithful believers that

have, over time, dispersed around the globe (Fisher, 2008). The belief in one God is the

universal principles that offer harmony and unity to all humanity (Fisher, 2008). The

Holy Quran lays down rules of personal behavior, manners toward others and relations

with society in order to assure the believer a safe passage (Fisher, 2008).

There are indeed a number of Divine injunctions in the Holy Quran, which justify the

validity of an insurance contract (Billah M. M., 2001). The contract of insurance contains

the elements of mutual cooperation17

(Billah M. M., 2001). It is a binding promise, which

binds both the insurer and the insured based on the general principle of contract18

(Billah

M. M., 2001). It also contains the elements of alleviation of hardships and provision of

material security and assistance for those who face unexpected risk and peril, and ensure

them a comfortable life19 (Billah M. M., 2001).

Hence, the Holy Quran is the principle guidance to provide an instrumental justification

for the application of insurance contract, as the Holy Quran is a plain statement 20 and

guidance for mankind in order for them to be successful in this world and in the hereafter

(Billah M. M., 2001).

15Also known as Sunnah.

16Analogical sources such as Qiyas, Istihsan and Ihtisab.

17See Al-Quran, Surah al-Maidah, 5:2.

18See Al-Quran, Surah al-Maidah, 5:1.

19See Al-Quran, Surah al-Baqarah, 2:201.

20See Al-Quran, Surah al-Imran, 3:138.


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1.4.2 The Sunnah

According to one hadith as quoted by Kettel (2008) in his book, one day the Prophet

(s.a.w) saw a Bedouin leaving a camel in the desert and he asked the Bedouin, Why

dont you tie down the camel?. The Bedouin answered, I put my trust in Allah. The

Prophet then said, Tie your camel first, then put your trust in Allah.

What the Prophet did was to encourage the Bedouin to reduce the risk of losing his

camel. Similarly, in many other actions of the Prophet, it is well documented that he took

steps to reduce risks (Kettell, 2008).

Another example was the Prophets actions during theHijra21. Feeling danger, he hid in a

cave instead of going straight to Medina (Kettell, 2008). He commanded is Companions

to migrate to Medina by batches instead of in one large group. Again this was to reduce

risks. When he went to war, he put on his armour instead of wearing light clothes

(Kettell, 2008).

1.4.3 Analogical Sources

There are many analogical sources which can be used for further justification for the idea

and practice of the insurance, so long as they do not contravene with the Holy Quran or

the Sunnah of the Holy Prophet (s.a.w). Some of the sources come from Al-Mursaleh al-

Mursalah, Al-Urf, Al-Fiqh, and Relevant Literatures of the Islamic Scholars, Unanimous

Decision of the Islamic Scholars, Acts of Parliament, Precedents as well as Rules of the

Shariah Supervisory Board. One example is given below:

Al-Urf22

The initial idea of Islamic insurance practices originated from the Arabs tribal custom

known as al-Aqilah, which was approved by the Holy Prophet (s.a.w) in a dispute

between two women from the tribe ofHuzail. Hence, this approved practice stand a validjustification for the validity of insurance.

21The migration of Muhammad s.a.w and his followers to Medina in 622AD.

22Al-Urf means custom, practice or usage of the community.


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1.4.4 Takaful Core Principles

There are 10 principles which made Takaful acceptable as stated by Billah M. M. ( 2001)

below:

(a)Principles of Contract

(b)Principles of Liability

(c)Principles of Utmost Good Faith

(d)Principles of Mirath and Wasiyah

(e)Principles of al-Wakalah (Agencies)

(f) Principles of Daman (Guaratntee)

(g)Principles of al-Mudharabah and al-Musharakah

(h)Principles of Rights and Obligations

(i) Principles of Humanitarian Law

(j) Principles of Mutual Cooperation

1.5Features of TakafulAn insurance practice under Islamic teachings possesses certain fundamental

characteristics upon which an insurance contract is to be held valid (Billah M. M., 2001).

Billah (2001) claims that the fundamental characteristics could mainly be classified into

four categories:

(a)Sincerity23

(b)Absolute Shariah Principles24

(c)Moral Attributes25

(d)Elements of Contract26

23Every transactions should be done with sincerity and pure intentions in order to achieve the desired results from

Allah s.w.t.24

Operations should not involved any elements which is not approved by the Shariah.25

An Islamic insurance contract should observe the principles of utmost good faith, honesty, disclosure as well as

truthfulness.26

Elements of contract should consists of legal capacities, subject matter, offer and acceptance.


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1.6Scope of Takaful ContractGenerally, the scope of an Islamic insurance policy is very wide and flexible. In spite of

the wide scope and flexibility of the Islamic insurance policy, there are certain limitations

set by the Shariah in order to purify the transactions (Billah M. M., 2001). For instance,

Allah (s.w.t) prohibits any kind of accumulation of profit and wealth by way just of

unjust enrichment27

(Billah M. M., 2001).

In short, the limitation imposed by the Shariah on an insurance policy may be outlined as

not to involve any element of Riba in its investments or any other activities (Billah M.

M., 2001).The results of Riba are that it contributes to the habit of selfishness,

miserliness, greed and malevolence, at the individual level and it may lead to a miserable

and unstable society (Billah M. M., 2001).

Thus, insurance policy must be based on the principle of al-Mudharabah as an alternative

to the principle of fixed-rate interest (Billah M. M., 2001). In addition, Billah (2001)

added that every individual in the society has freedom of having an insurance policy.

Only two reasons which made a person may not enter into a contract of insurance:

(a)The age factor

A minor or infant below the age of 15 should also have the right to be insured

provided that, the policy is completely under the supervision of the respective

guardian and also for the benefits of the underage person.

(b)Insanity or Medical Unfitness

A person who is insane or medically unfit as certified by a medical doctor may also

be incapable to enter into an insurance policy.

Finally, all kinds of insurance practices should be dealt under the supervision of the stateauthority (Billah M. M., 2001).

27This statement condemns gaining profit by the means of Interest and Gambling.


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1.7 Takaful and its Current Regulations, Issues and Challenges

Important current operational, legal, accounting, and financial as well as risk management issues

will be covered in the following sections. The public and the market are requesting greater

transparency and better financial reporting. Transparency is required in order to better reflect the

structure of the companies that are being established, as well as in the reporting of their

performance and financial position. Transparency is also requested in connection with

stakeholders rights, including those of policyholders (Archer, Abdel Karim, & Nienhaus, 2009).

2.0DisclosureRequirements, Contents and ScopeTransparency and disclosure

28provisions serve two purposes. On the one hand, they are a

prerequisite for comparisons of products and services and they facilitate informed choices of

consumers.

2.1Multiple fees and chargesIn the Gulf region, the Takaful Operator benefits from a high volume of underwriting,

due to (Archer, Abdel Karim, & Nienhaus, 2009):

(a)An upfront payment in the first year, calculated as a percentage (30-60%) of the first

years contribution;

(b)Annual fund management charges of 1.5% of the value of the funds under

management; and

(c)Contract administration charges of 0.25% of the fund value.

In the end, the Takaful Operator receives a share of 30% of the profits earned by

investments of the PTF (Archer, Abdel Karim, & Nienhaus, 2009). The remaining

portion of the investment profit belongs to the participants, but it is not paid out to them;

instead it is retained in the PTF until the event of death, surrender, or maturity (Archer,

Abdel Karim, & Nienhaus, 2009). These retained profits can be invested again with a

profit share for the Takaful Operator (Archer, Abdel Karim, & Nienhaus, 2009).

28On the other hand, they are needed for a better understanding of the functioning and the systematic qualities of

Takaful business models as alternatives to conventional insurance. Both dimensions have regulatory implications.


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Most components of the remuneration of the Takaful Operator are directly proportionate

from the volume of Takaful contributions collected from the participants (Archer, Abdel

Karim, & Nienhaus, 2009). Takaful Operators, with such a remuneration structure have

strong incentives to increase the volume of contributions. This is done by increasing the

number of participants as well as fixing contributions above the risk adequate level

(Archer, Abdel Karim, & Nienhaus, 2009).

According to the Authors, as long as transparency is generally low, consumers are

lacking in education in and experience with insurance products, information asymmetries

prevail, and the number of Takaful Operator is very limited, at least some milder forms of

regulation, for instance, disclosure requirements could be considered (Archer, Abdel

Karim, & Nienhaus, 2009).

2.2Commissions (in family Takaful)In family Takaful, the commission to be paid to the distribution partner poses a major

problem (Archer, Abdel Karim, & Nienhaus, 2009). The commission is generally

calculated as a percentage of the underwritten amount, including the savings component

of a contract. For long-term contracts, this commission is usually paid upfront after the

contract has become effective (Archer, Abdel Karim, & Nienhaus, 2009). The

commission payment may well exceed the total amount of the participants contributions

in the first year. As a result, the surrender value of conventional life insurance is very low

or even zero. In Takaful, a commission can be paid only if its for the underwriting

elements only (Archer, Abdel Karim, & Nienhaus, 2009). Therefore it looks excessive at

the participants part29

.

An alternative to surplus sharing could be to pay the commission not upfront but pro rata

over the term of the contract (Archer, Abdel Karim, & Nienhaus, 2009). But if Takaful

products compete with conventional insurance policies for the support of distribution

partners, and if conventional insurers pay commission upfront, Takaful Operators would

seriously be at loss (Archer, Abdel Karim, & Nienhaus, 2009).

29This may not be sufficient to cover what is due to the distribution partner.


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In order to overcome this, Shariah scheme for the transformation of future pro rata

payments into an upfront lump sum payment will be initiated (Archer, Abdel Karim, &

Nienhaus, 2009).

3.0 Financial Reporting for Takaful Operations

Islamic insurers have different structures and face different risks which require a specific

financial reporting framework; therefore they could not adopt the same International Financial

Reporting Standards as their main reporting framework (Archer, Abdel Karim, & Nienhaus,

2009). Full transparency in financial reporting is needed in order to address the increasing

concern of regulators and standard setters for insurance companies whether conventional or

Takaful (Archer, Abdel Karim, & Nienhaus, 2009).

Therefore, this had led to the issuance by the Accounting and Auditing Organization for Islamic

Financial Institutions of two financial accounting standards for Islamic insurance in year 2000

and 2001 respectively30

(Archer, Abdel Karim, & Nienhaus, 2009). One of its objectives is to

address the specificities of Islamic insurance companies, especially with respect to

policyholders rights in underwriting funds and the movements in these funds (Archer, Abdel

Karim, & Nienhaus, 2009).

3.1Future FinancialReporting TrendsThe Takaful stakeholders have access to better-quality financial information from more

sophisticated markets and expert to obtain similar information from the Takaful markets

(Archer, Abdel Karim, & Nienhaus, 2009). These increasing expectations are putting

more pressure on Takaful companies to disclose voluntarily financial information that

they would not otherwise have disclosed (Archer, Abdel Karim, & Nienhaus, 2009).

AAOIFI responded to the increasing demands for better financial reporting that takes into

account the specificities of Takaful companies by issuing two standards on Islamic

insurance companies (AAOIFI Standards 12 and 13). This is the start of the financial

30AAOIFI had come up with two standards related to Islamic insurance as basis of Islamic insurance financial

reporting requirements. However, this is to be improved more.


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reporting of Takaful companies to specifically address the disclosure of policyholders

rights in accumulated funds (Archer, Abdel Karim, & Nienhaus, 2009).

Below is the AAOIFI standards that deal with Islamic insurance companies were issued

in 1999 and 2000:

1. Financial Accounting Standard No.12 (FAS 12):General Presentation and

Disclosure in the Financial Statements of Islamic Insurance Companies;and

2. Financial Accounting Standard No.13 (FAS 13): Disclosure of Bases for

Determining and Allocating Surplus or Deficit in Islamic Insurance Companies.

However, bear in mind that these standards are only basic; AAOIFI still has a long way

to go in order to improve Takaful Operations financial reporting matters.

In addition, it is stressed by Archer, Abdel Karim, & Nienhaus (2009) that financial

reporting is useful when it is accessible to stakeholders in a timely manner,

understandable, and comparable to that of other Takaful companies. Relevant, reliable

and useful financial information that addresses the needs of stakeholders through an

adequate and enforceable financial reporting framework are crucial.

Greater transparency can also be ahieved as finalized below (Archer, Abdel Karim, &

Nienhaus, 2009):

(a)Proper application of the financial reporting framework is enforced by the regulators

and the markets31.

(b)Harmonization and proper communication of Shariah supervisory boards decisions

and fatwa32

.

(c)Enhanced disclosures on policyholders funds, allocation of surplus to policyholders,

and income from prohibit transactions33.

(d)Robust corporate governance rules are implemented34.

31 Proper application of AAOIFI standards would provide the stakeholders of Islamic insurance companies with significant

information on the relationship between the shareholders and the policyholders.32

This is to ensure the operations are in accordance with the Shariah principals, Shariah supervisory are to be employed to

regulate Takaful activities, products sold and investment strategies.33

AAOIFI standards require disclosures on policyholders funds and the determination and allocation of surplus and financing of

deficits. Furthermore, individual rights of the policyholders should be clearly states in the financial statements.


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Other future development for Takaful as mentioned by Ahmad (2010) in his talk at INCEIF was:

y Use of internal models (instead of prescribed factors)

y Profit Recognition at inception, which considered at Service Margin based on the service

given.

y Risk Base Capital for Takaful in Malaysia

y IFRS 4 for Takaful reporting, this year 2010

4.0 Government Service Tax for Takaful Operations

Issues with Takaful Operators is that in some countries, the tax laws in some countries may not

have considered the peculiar nature of Takaful contracts and in cases like this the TakafulOperators may lose out in comparison with conventional insurers (Ismail & Abdul Razak, 2010).

This is true for general Takaful business whereby at times the tax regime and the laws and

regulations governing the Takaful industry may not have been harmonized (Ismail & Abdul

Razak, 2010).

For example, the Insurance/Takaful regulators may require that Takaful operators in their

jurisdiction comply with reporting revenue of a given statutory basis which may result in the

operator being liable to tax which it would not otherwise have been subject to had the reporting

been on a different basis (Ismail & Abdul Razak, 2010). This additional tax liability by the

Takaful Operator may also be due to some other reason not necessarily due to regulatory

requirements. And example would be if the Shariah Advisor (s) requires the Takaful Company to

follow a certain basis of reporting (Ismail & Abdul Razak, 2010).

Another Issue with respect to taxation is the payment of zakat35

, the payment of zakat should not

be given full rebates, therefore Takaful Operators would be disadvantaged compared to insurers

(Ismail & Abdul Razak, 2010). This is compounded by the fact some Shariah Advisor (s) require

that the zakat payable be based on net current assets and not on profits; this advantaging the

Takaful company further especially in the early years (Ismail & Abdul Razak, 2010).

34This is to ensure adequate disclosure of relevant information about the companys investment objectives and

policies, and operational guidelines that govern the relationship between the shareholders and the policyholders.35

Some contemporary Scholars advocate that the payment of zakat is not considered as tax-deductible expense.


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5.0 Basel II Requirements on Risk Based Capital

The Risk Base Capital simply means the capital needed to support the solvency of a Takaful fund

should be related to the actual risks faced or covered by the Takaful fund (Ismail & Abdul

Razak, 2010). This makes intuitive sense since the capital is to maintain solvency, the degree of

capital needed should fairly reflect the risks covered by the fund (Ismail & Abdul Razak, 2010).

The concept of Risk Base Capital has found increasing acceptance in financial circles with banks

worldwide adopting global capital adequacy standards which are essentially risk based (Ismail &

Abdul Razak, 2010). In the Takaful sector, the concept of Risk Base Capital may also be applied

with the understanding that it is the Takaful fund which needs to have sufficient assets to meet

minimum solvency of Risk Base Capital requirements (Ismail & Abdul Razak, 2010).

Familiar as the above, Wikipedia (2010) states that capital requirement is a bank regulation,

which sets a framework on how banks and depository institutions must handle their capital. The

categorization of assets and capital is highly standardized so that it can be risk weighted

(Wikipedia, 2010). Internationally, the Basel Committee on Banking Supervision housed at the

Bank for International Settlements influence each country's banking capital requirements

(Wikipedia, 2010). In 1988, the Committee decided to introduce a capital measurement system

commonly referred to as the Basel Accord (Wikipedia, 2010). This framework is now being

replaced by a new and significantly more complex capital adequacy framework commonly

known as Basel II. While Basel II significantly alters the calculation of the risk weights, it leaves

alone the calculation of the capital (Wikipedia, 2010). The capital ratio is the percentage of a

bank's capital to its risk-weighted assets. Weights are defined by risk-sensitivity ratios whose

calculation is dictated under the relevant Accord. Each national regulator normally has a very

slightly different way of calculating bank capital, designed to meet the common requirements

within their individual national legal framework (Wikipedia, 2010)

In June 2006, Basel Committee had come up with a revised Banking Supervision for Insurance

entities as the mentioned below (BIS, 2006):

Article number 30 mentioned that a bank that owns an insurance subsidiary bears the full

entrepreneurial risks of the subsidiary and should recognize on a group-wide basis the risks

included in the whole group. When measuring regulatory capital for banks, the Committee


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believes that at this stage it is, in principle, appropriate to deduct banks equity and other

regulatory capital investments in insurance subsidiaries and also significant minority investments

in insurance entities. Under this approach the bank would remove from its balance sheet assets

and liabilities, as well as third party capital investments in an insurance subsidiary36

(BIS, 2006).

Furthermore, Article 31 states that due to issues of competitive equality, some G10 countries will

retain their existing risk weighting treatment as an exception to the approaches described above

and introduce risk aggregation only on a consistent basis to that applied domestically by

insurance supervisors for insurance firms with banking subsidiaries. The Committee invites

insurance supervisors to develop further and adopt approaches that comply with the above

standards (BIS, 2006).

In addition, Article number 32 confirms that Banks should disclose the national regulatory

approach used with respect to insurance entities in determining their reported capital positions. It

has been prolonged to Article 33 that all the capital invested in a majority-owned or controlled

insurance entity may exceed the amount of regulatory capital required for such an entity (surplus

capital). Supervisors may permit the recognition of such surplus capital in calculating a banks

capital adequacy, under limited circumstances.10 National regulatory practices will determine

the parameters and criteria, such as legal transferability, for assessing the amount and availability

of surplus capital that could be recognized in bank capital (BIS, 2006). Other examples of

availability criteria include: restrictions on transferability due to regulatory constraints, to tax

implications and to adverse impacts on external credit assessment institutions ratings. Banks

recognizing surplus capital in insurance subsidiaries will publicly disclose the amount of such

surplus capital recognized in their capital (BIS, 2006). Where a bank does not have a full

ownership interest in an insurance entity (e.g. 50% or more but less than 100% interest), surplus

capital recognized should be proportionate to the percentage interest held. Surplus capital in

significant minority-owned insurance entities will not be recognized, as the bank would not be in

a position to direct the transfer of the capital in an entity which it does not control (BIS, 2006).

36 Alternative approaches that can be applied should, in any case, include a group-wide perspective for

determining capital adequacy and avoid double counting of capital.


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Finally, in Article 34, all Supervisors will ensure that majority-owned or controlled insurance

subsidiaries, which are not consolidated and for which capital investments are deducted or

subject to an alternative group-wide approach, are themselves adequately capitalized to reduce

the possibility of future potential losses to the bank (BIS, 2006). Supervisors will monitor actions

taken by the subsidiary to correct any capital shortfall and, if it is not corrected in a timely

manner, the shortfall will also be deducted from the parent banks capital (BIS, 2006).

Apart from this, the tasks for insurance regulators in attempting to develop new standards for

risk-responsive solvency requirements for the sector was, to some extent, simplified by the trail

blazed in the banking sector by the Basel Committee for the Banking Supervision. The Basel

Accords incorporated a conceptual framework for supervision of banks (Archer, Abdel Karim, &

Nienhaus, 2009). The Authors includes that:

(a)The classification of capital into tiers of different quality

(b)Consistent rules on valuation of assets and liability

(c)The identification of different classes of risks

(d)The setting of capital requirements based on defined probability of failure

(e)The possibility of using internally developed capital models, rather than a standard

approach; and

(f) An active role for the regulator in assessing risk management and, if necessary,

penalizing poor risk management by imposing additional capital requirement.

As an example given by Ahmad (2010) on how Risk Base Capital is being practiced

internationally is by:

Fair Value Accounting Standards where the best estimate provisions are taken

Protection of customers shifted to Capital Requirements, whereby it;

Does not impact Profit & Loss Account

Consistent with Basel and Solvency 2

Risks identified & Capital Requirements specific to the Business Entity.


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Risk Base Capital requirements are mainly (Ahmad, 2010):

Two Approaches:

99.5% Confidence of Capital Adequacy over 12 month period

Confidence of Capital Adequacy over the term of the Contract

Malaysia follows first approach where it aligns with Solvency 2

Prescribed factors are used to compute Capital Requirements for Market,

Credit & Operational Risk

Liability Capital Charge is computed by taking the difference of a reserve

based on operational cash flows with prescribed loading factors with the

normal reserve

Mismatch Risk is computed by shocking the discount rates by prescribed

factors and taking the worst resulting scenario

However, since Risk Base Capital requirements are still a relatively recent innovation, Bank

Negara Malaysia said that the implementation of the revised capital frameworks for the banking

and insurance industries in the country would remain as its key priority in this year.

6.0 Are Current Takaful Regulations Appropriate?

In my opinion, the current Takaful Regulation is not appropriate enough. This is due to the fact

that one of the main challenges confronting the Takaful industry is the raising awareness among

its various stakeholders (Archer, Abdel Karim, & Nienhaus, 2009). The authors suggest that the

misconceptions about insurance cover among potential consumers would have to be dispelled, so

as to foster greater acceptance of Takaful37


In addition, regulators too would also need to develop a full understanding of the risks to ensure

that the Takaful operations within their jurisdictions are adequately regulated and supervised.

Apart from this, all stakeholders, including rating agencies and standard-setting bodies, shouldalso not lose sight of an important objective in the Takaful industry, which that is to ably meet

the rising consumer demand in the most cost-effective manner (Archer, Abdel Karim, &

37Thus, providers of Takaful would need to acquire stronger and more in-depth understanding of the technical,

operational, legal and Shariah requirements for Takaful operations, if they are to broaden the range of Takaful

products they offer and raise the quality of their services.


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Nienhaus, 2009). Only by the abovementioned matter then can this nascent industry grow and

develop in a sustained path and reach a wider segment of consumer, both Muslim and non-

Muslims (Archer, Abdel Karim, & Nienhaus, 2009). Drawing lessons from the present financial

crisis38, Takaful Operators will also need to have in place robust risk management and corporate

governance systems in order to be able to serve their customers well over the longer-term


7.0 Recommendations

Takaful is the Islamic alternative to conventional insurance. However, unlike conventional

insurance which is relatively standardized, Takaful operates under three different models (Kabir

& Lewis, 2007). These three models bring the principles of cooperation, solidarity and

brotherhood that underlie Takaful (Kabir & Lewis, 2007).

The Takaful models39

in the market are all in line with the principles of Shariah. Nevertheless the

system as a whole would benefit at the global level if Takaful practitioners, Shariah experts and

Governments authorities employed mutual cooperation and understanding to reconcile some of

the differences that have arisen (Kabir & Lewis, 2007).

Proper regulation and supervision of banks and financial institutions is also important for

financial efficiency and stability (Kabir & Lewis, 2007). Some of the risks faced by the Islamic

financial industry are unique because of the requirement of Shariah compliance. Bank

supervisors utilizing the traditional standards cannot assess such risks (Kabir & Lewis, 2007).

Therefore, the need for special guidelines for the regulation and supervision of Islamic banks has

long been felt (Kabir & Lewis, 2007).

In addition, with an active involvement of the International Monetary Fund (IMF), the IDB and

support of the Bahrain Monetary Agency (BMA), Bank Negara Malaysia (BNM), and some

other central banks, an Islamic Financial Services Board was established in Malaysia in

November 2002 and has been in operation since March 2003 (Kabir & Lewis, 2007). Its mandate

38Subprime crises had been regarded as a cause which leads to the financial instability.

39The three alternatives of Takaful Models are, Wakala, Mudaraba and Tijari.


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is to serve as an international standard-setting body of the regulatory and supervisory agencies

that have an interest in ensuring the soundness and stability of the Islamic financial services

industry40 (Kabir & Lewis, 2007). For example, the IFSB will promote the development of a

prudent and transparent Islamic financial services industry through introducing new, or adapting

existing, international standards consistent with Islamic principles, and recommend them for

adoption (Kabir & Lewis, 2007). This complements that of the Basel Committee on Banking

Supervision, International Organization of Securities Commissions and the International

Association of Insurance Supervisors (Kabir & Lewis, 2007).

8.0 Conclusion

Although there is no doubt that the emerging Islamic financial architecture requires further

strengthening, two other requirements are also urgent. One is the need to consolidate the

emerging set-up and to coordinate the activities of the newly established institutions so as to

avoid any complications.

The other is the need to integrate the Islamic financial architecture into the global institutional

framework without losing its specificities. Therefore, this will certainly benefit Takaful Industry

as a whole internationally. In this respect the impact of the current trend towards globalization as

well as the technological developments which are changing the shape of financial firms need to

be seriously considered and responded to. The Islamic financial industry has a bright future, but

it will be achieved only if the past achievement on the one hand and the floodlight of imminent

changes on the other do not blind its active players.

40Define broadly to include banking, capital market and insurance.


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Bibliography

Ahmad, Y. A. (2010, April 7). Role of Actuary Risk Based Capital (RBC). Kuala Lumpur, Malaysia: CIMB

AVIVA.

Archer, S., Abdel Karim, R. A., & Nienhaus, V. (2009). Takaful: Islamic Insurance Concepts and Regulatory

Issues. Singapore: Wiley.

Billah, M. M. (2003). Islamic and Modern Insurance: Principles and Practices. Selangor: Ilmiah Publishers

.

Billah, M. M. (2001). Principles & Practices of Takaful and Insurance Compared. Kuala Lumpur: IIUM

Press.

BIS. (2006). Basel Comittee on Banking Supervision:International Convergence of Capital Measurement

and Capital Standards. Bank for International Settlements , 1-347.

BNM. (2010, February 16). Retrieved February 16, 2010, from Bank Negara Malaysia: www.bnm.com.my

Fisher, O. C. (2008). Takaful Markets and Products. Red Money Books.

Getubig, I., & Schmidt, S. (1992). Rethinking Social Security: Reaching Out to the Poor. Kuala Lumpur: SP

Muda Printing.

Iqbal, M. (2005). General Takaful Practices: technical approach to eliminat gharar (uncertainty), Maisir

(gambling) and Riba (usury). Jakarta: Gema Insani Press.

Ismail, E., & Abdul Razak, D. S. (2010). Takaful and Actuarial Practices. Kuala Lumpur: INCEIF.

Kabir, M. H., & Lewis, M. K. (2007). Handbook of Islamic Banking. Great Britain: Edward Elgar.

Kettell, B. (2008). Introduction to Islamic Banking & Finance. Northampton: Printhaus.

Razak, S. H. (2009). Wealth Planning and Management. Kuala Lumpur: Inceif.

Venardos, A. M. (2006). Islamic Banking and Finance in South East Asia: Its Development and Future.

Singapore: World Scientific Publishing.

Wikipedia. (2010, March 9). Capital Requirement. Retrieved April 4, 2010, from

http://en.wikipedia.org/wiki/Total_Risk-Based_Capital

Yap, A. F. (2009). Takaful: Effective Marketing & Sales Practices. Kuala Lumpur: IBFIM.

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