Excess of loss retakaful is not Shariah compliant?

On a sunny Friday afternoon, a young PhD candidate in Islamic Finance came for a discussion about non-proportional method of retakaful. She brought with her an ISRA paper that briefly touched this topic but not conclusive in any way. She had the impression that authors question shariah compliance of non-proportional retakaful method. The reason being is that, unlike proportional method, there is no actual sharing between takaful risk fund and retakaful risk fund in non-proportional structure.

More recently, Dewan Syariah Nasional of Majelis Ulama Indonesia (DSN-MUI) is discussing whether non-proporsional retakaful is shariah compliant, which may end up with fatwa on this matter. If the fatwa decided that non-proportional retakaful is not shariah compliant, it may bring significant impact to the market as non-proportional retakaful has been widely used globally.

Scholars at DSN-MUI so far incline to a view that risk sharing element is absent in non-proportional retakaful. What does exist is actually transfer or sharing of loss, as suggested by its name, excess of loss. What we are not sure at this stage is how deep scholars understanding on excess of loss and how it works. I sense there may be misunderstanding or misperception on certain key concepts such as risk, loss, proportional vs non-proportional, risk sharing vs risk transfer.

This write-up aims to discuss this issue and hopefully to clear the cloud by providing a fair understanding on the non-proportional retakaful. Let's begin by aligning everyone understanding on basic of proportional and non-proportional method.

Proportional Retakaful

Let's assume a big mansion has sum insured or sum covered of RM 100 million. The owner decided to take up fire takaful from Takaful Operator (TO) ABC. He pays a contribution of RM 1,000 per annum.

Takaful Participant Fund or Takaful Operator Risk Fund (TO RF) managed by takaful operator ABC is able to retain loss up to RM 25 million only. TO ABC then arranges a proportional retakaful cover for remaining RM 75 million, provided by Retakaful Operator (RTO) XYZ. In other word, 75% of the risk is now actually borne by risk fund managed by RTO XYZ. As consequence of releasing 75% of risk to XYZ, ABC has to forward 75% of contribution to XYZ (RM 750).

This is Quota Share retakaful, a basic form of proportional method of retakaful, as pictured below:

Suppose a small fire occured and burn kitchen of the mansion and raise a claim of RM 5m. Risk Fund of ABC will pay 25% of it (RM 1.25m) and remaining 75% (RM 3.75m). Applying the same logic, for a claim of RM 20m, Takaful and Retakaful risk fund will be liable to RM 5m and RM 15m respectively.

In the case of a very unfortunate event of massive fire that burns the mansion completely down and cause a total loss, Takaful Risk Fund will pay maximum 25m and RM 75m to be borne by Retakaful Risk Fund.

As we can see, regardless of size, any claim will be split 25% : 75% between Takaful Risk Fund and Retakaful Risk Fund. Retakaful Risk Fund participates in each and every loss, regardless of the size.

Under this mechanism, it is very easy for most people to see perfect risk sharing in proportional retakaful.

Excess of loss retakaful

Takaful Operator ABC actually has other option with the same impact of limiting its risk fund liability up to RM 25 million, simply by rotating the chart 90 degree anti-clockwise. It turns into excess of loss arrangement or non-proportional retakaful.



Despite its maximum liability of both parties is limited to the same level as QS, the mechanic how risk or loss being distributed is very different. Takaful Risk Fund begin to benefit from retakaful cover only when the loss is higher than 25 million. Retakaful risk fund will pay any amount above (or in excess) 25m. Any loss up to 25m will need to be borne by Takaful Risk Fund and retakaful pays nothing. From example above, loss of 5m and 20m are fully retained by Takaful Risk Fund. In other words, there is no proportional relationship between liability of Takaful and Retakaful risk fund. Many see the absence of this proportional relationship as the absence of risk sharing. Opinion that lead to serious conclusion that excess of loss is not Shariah compliant.

I beg to differ

I personally disagree with the above consclusion that non-proportional or excess of loss retakaful is conflicting with Shariah, supported by at least three arguments below.

No explicit prohibition

The main problem of conventional insurance from shariah point of view is the fact that it works on the basis of risk transfer. Risk is transferred from an insured to insurer (insurance companies). Risk or uncertainty is being exchanged with premium. Shariah views this as trading of uncertainty, which is equal to gambling.

Shariah does recognize existence of risk or uncertainty and permit or even encourage effort to mitigate or manage it. Risk management is completely lawful under shariah. The only issue is that shariah does not allow risk or uncertainty to be subject matter of any exchange or buy-sell or commercial contract. You should not trade uncertainty.

Shariah has solution to this problem i.e. sharing of risk. Instead of transferring risk to other party, risk is now being shared among owner of identical or similar risks on the basis of helping or guaranteeing each other. It is no longer commercial in nature anymore, it is benevolent.

How exactly this risk sharing among risk owners to be done in practice, either on proportional or non-proportional, Shariah does not provide detail guidance. Shariah does not explicitly forbid non-proporsional risk sharing either. It is up to consideration, innovation and agreement amongst the parties. Perhaps, the only restriction is that whatever method used and agreed, it should be fair to all parties involve. Well, this is standard condition for all kind of relationship anyway.

Fairness

So, next question will be: is non-proportional arrangement fair for all parties?

Main indicator of fairness here is whether contribution received by each Risk Funds commensurate to level of risks being assumed by each of them. Under QS it is pretty clear, since Retakaful Risk Fund bears 75% of each and every loss, it deserve to receive 75% of contribution.

Under non-proportional arrangement, it may be a little bit tricky as Retakaful Risk Fund will only involve when loss is higher than 25m. It does not pay anything at all if loss falls below that level. It does not participate in each and every loss. On the other hand, Takaful Risk Fund does participate in each and every loss. Takaful Risk Fund is liable to any loss from zero to retention level. So, in this case, exposure to loss is not the same between two risk funds. Takaful Risk Fund is more exposed than Retakaful Risk Fund. Therefore, Takaful risk fund is entitled to higher contribution than Retakaful Risk Fund. Isn't it fair? I personally believe so, it is a just arrangement.

Policy deductible is against shariah?

Apart from its application in reinsurance and retakaful, non-proportional or excess of loss structure has been used in most of direct insurance and takaful policy. Take your car policy and check whether it has something call excess or deductible or own risk.

How does it work? Let's say you policy cover your car value of RM 200,000 and it has excess RM 300. It means you as owner of the car will always be responsible to pay any loss up to RM 300. Your insurer will only pay the balance above that level. If your loss less than USD 300, too bad, you have to pay all out of your pocket. Nothing you can claim to insurer or takaful operator. We can describe this structure in next chart.

Take a look for a while, does it looks like non-proportional arrangement? Well, it does not only look like actually, but it is in fact a non-proportional structure or excess of loss. So, application of deductible or excess in direct takaful policy is basically a non-proportional arrangement. If we say excess of loss retakaful is not shariah compliant we have to also admit that all takaful policies with deductible or excess are not Shariah compliant either, will we?