Why Takaful Struggles to Penetrate Large Commercial Risks?

Takaful, as one of Shariah-compliant alternative to insurance, has been around for more than three decades now, since first Sudanese takaful operator began its operation in 1979.  From early 80's, Malaysian has come forward as most advanced takaful market, thanks to government persistence to push Islamic Finance.

Saudi Arabia and the rest of GCC countries, Indonesia, Pakistan are now growing their takaful (or Islamic insurance rather) markets quite rapidly.  Not to mention massive potential hidden by countries like Turkey, India, China, Nigeria, Egypt and other African countries, and also Central Asia region.  We might even see interesting takaful development in Europe, America and Australia to serve their Muslim community and Non-Muslim segments who have growing concern over fairer, less speculative and more communal finance.  Africa could be next powerhouse of Islamic Finance, bearing in mind Muslims make up about half of continent population and its exciting economic growth.

Various reports and statistics keep optimistic outlook on takaful, some still stick to double digit growth due to sheer empty space for penetration.  Some are more realistics by recognizing that takaful shown a slight slower acceleration, especially in frontrunning markets such as Malaysia, Indonesia and Middle East.

However, the most eye-catching phenomenon for me is that takaful globally remains significantly be dominated by family takaful.  When we further zoom in to general takaful slice, we shall find another interesting fact that general takaful is massively skewed toward personal lines such as motor, personal accident, medical and householder/houseowner.  Commercial lines are really small tiny slice in takaful cake.  In other words, takaful is simply irrelevant to global commercial line sphere.

Why? What's going on?

I have heard and read people put forward some analysis, such as lack of expertise, lack of awareness, lack of government support, lack of capital etc..etc.  In my opinion, none of those really touch on core of issue.  All tend to describe or explain symptoms.

Let's dig into this matter slowly.

We should be aware by now that takaful provide protection against risk under risk sharing instead of risk transfer.  Risks are shared among owners of similar risks, instead of being transferred to insurance companies.  Insurance companies role has been reduced from risk bearer to mere takaful scheme manager, for which they are eligible for remuneration.  Under wakala model, for example, this remuneration given by way of wakala fee.  In managing takaful scheme, insurance companies or takaful operator to be exact, carry out various activities such as marketing, underwriting, claim handling, accounting, reserving, investing fund etc, which are basically the same activities done by conventional insurance companies.  Therefore, apart from shariah-compliance, takaful operators will need more or less the same skill sets that conventional will do.                 

Under takaful, insureds or participants collectively act as risk bearer, not takaful operator.  Risk bearing capability of each participant are pooled and financially reflected though risk fund or tabarru' fund managed by takaful operator.  So, the ultimate objective of the takaful scheme is to ensure money pooled in the risk fund is adequate to pay losses.  If money is inadequte, in principle, either claimant to receive less payment or all participants to top-up the fund.

Risk Portfolio Characteristics

Takaful pooling system works perfectly for risk portfolio with following characteristics:

- Low range or less variation of sum insured. Range here is defined as maximum value less minimum value

- Relatively low average sum insured.

- Large number of population of the same or similar risks, law of large number is applicable.

- Homogenous in terms of risk natures and features that lead to simple loss model.  As risk is homogenous, how it might transform into loss is easy to understand.

All these four characteristics lead to low volatility, that means more predictable outcome.  Overall this kinds of portfolios are very much manageable by simple pooling system of takaful.  This is one of important factor that allow takaful for personal lines grow rapidly.

Whereas commercial risks portfolio has completely opposite characteristics:

- High range or high variation of sum insured.  Range here is defined as maximum value less minimum value. In other words, commercial risks consist of item with relatively low value to very high value.

- Relatively high everage sum insured.

- Number of population of the same or similar risks can be small, law of large number may not be applicable.

- Heterogenous in terms of risk natures, types, features and behaviors that lead to complex loss model.  As risk is heterogenous, how it might transform into loss is not easy to understand as many factors interact with each other in variety of ways, leading to many loss scenarios that might prevail. 

These lead to high volatility and more unpredictable outcome.  Pooling system of takaful becomes less effective in managing this kind of portfolio.  Well, it is, theoretically speaking, possible if we can have very big pool to absorb high volatility.  Here is the challenge, building big enough pool capable to swallow high volatility is not an easy task, if it is not impossible.  Retakaful may help to grow the pool size, but still not enough.  Even in conventional insurance and reinsurance sphere, which actually also work on virtual pool, big enough pool may have never been reach.

Consumers Characteristics

Furthermore, as the name suggests, participant or insured of personal lines are individual.  As a person, they are fully responsible individually in making decision on how they are going to handle their risk, whether to buy conventional insurance or participate in takaful scheme. This decision, like any other decision making, will be very much shaped by their personal believe and value.  A Muslim will be driven or at least influenced by his or her Islamic religious believe and value.  Therefore, when they are given two choices, conventional insurance or shariah-compliant takaful, probability that they will opt takaful is pretty high.  

Even if someone is not that pious and tend to be rational than emotional in decision making, when both options giving similar values, they may still lean toward takaful solution.  Shariah compliance may not be too critical for them, but at least can be considered as a bonus.  

Unlike personal lines, the insured or participant of commercial lines are organization, mostly commercial organization.  An adjective of "religious" can not be used to describe them, unless in rare circumstances where the corporation is strongly controlled by very religious person.  Shariah compliance sentiment is irrelevant to them.  Almost all their decisions are rational and financially driven.  Very conventional mindset of 'acquire anything at lowest possible cost' applies.  This mindset can also be translated into 'grab upside values as much as possible, and let them swallow all downside risks".  It is very much a risk transfer mentality.  Marketing takaful solution to them using personal line way will definitely useless.      

This is second explanation why takaful is very successful in personal lines, in addition to first explanation on risk portfolio characteristics above.

Re/takaful is less "Sexy" and Dilemma of Qard Hasan

Perhaps, due to risk transfer principle, building such pool in conventional insurance/reinsurance is easier than in takaful/retakaful.  Many insurers/reinsurers may dissappear over time, especially after certain shock such as huge natural catastrophe or economic crisis.  But, there will be always new breed of investors willing to risk their fortune, pouring capital into re/insurance industry hoping handsome profit.  Post Hurricane Andrew in 1992, there have been innovation that allow transferring risk to capital market rather than re/insurance industry, via Insurance Linked Security (ILS) or Catastrophe Bond. Therefore, virtual pool may be shrinking at certain stage, but replenished soon, or even grow bigger than before.

As Re/takaful works on risk sharing basis, it may be less "sexy" than re/insurance from investors point of view.  Acting as mere Manager of the risk sharing scheme limits possible revenue of re/takaful operator to the fee based income, such as wakala fee.  While under conventional re/insurance, because all risks are transferred to the company, including underwriting risks, naturally all revenue being fee base, underwriting profit and invesment yields, belong to the company.

The concept of qard hasan, that is instilled into re/takaful system, creates another complication and makes re/takaful even less attractive to investors.  Qard hasan is a benevolent loan provided by re/takaful operator (shareholders' fund) to the risk fund in the situation where risk fund in deficit state.  Depending on the regime and circumstances, this qard hasan can be in form of real cash transfer from shareholder bank account or merely accounting record showing that shareholder money is used or ring-fenced to support deficit risk fund. 

No doubt that qard hasan remains subject of ongoing debates and becomes most controversial element of re/takaful.  Some critically argue that qard hasan has fundamentally changed nature of takaful, converting risk sharing takaful back into risk transfer insurance.  Qard hasan has made capital requirement for takaful operator make sense (on top of mere capital to support operation).  This capital is expose to underwriting risks through qard hasan.  This is it! This is the twist.  Exposing shareholders' wealth to underwriting risk, despite indirectly, in principle transforms the very nature of re/takaful operators from risk manager to risk carrier, as their conventional re/insurers counterpart.  Suddenly re/takaful fundamentally has no difference from conventional re/insurance.  Are we cheating public with re/takaful proposition?           

Can we have takaful without qard hasan? The answer is theoretically yes.  As mentioned above, when risk fund becomes deficit, in principle, either claimants shall receive less compensation from the fund or all participants shall top-up the fund.  This is very logic solution as all participants are collectively risk carriers.  However, this principle may be impractical under current financial environment and public mindset.  It could have been the weakest link that prevent takaful in featuring itself as alternative to non-shariah compliant conventional insurance.  Will you switch to takaful when you are told that if the pool is running out of money, you will need to pay extra otherwise your claim will be paid less or even no claim will be paid at all?  Therefore, it is important to note that qard hasan perhaps the compromized solution, for the time being at least, in order to make takaful concept economically viable, at least from participant point of view.   Sooner or later, qard hasan dilemma needs to be resolved.

So....

Sorry to set your expectation a bit too high in the beginning.  Unfortunately, we have not yet offered any solution to question in the title of this article.  We have just tried to dig deeper to understand the issue.  We definitely need to continue this discussion.