In operator does not contribute to any incremental growth

In
takaful, the surplus is defined as an asset minus the liability of takaful risk
fund. Surplus exists due to the difference between actual experience and price
assumptions. Total of surplus depends on how assets and liabilities of the
takaful fund are assessed. Surplus can be split among participants
(policyholders), to takaful operators (shareholders), and keep in the fund for
contingencies.

 

The surplus of the tabarru
‘account to be distributed between participants and takaful operators is based
on the fact that takaful contracts are generally built on tabarru’ (donation)
and ta’awun (help-assist) along with mutual consent between parties. Tabarru is
a key principle that underlies takaful products. Other shari’ah principles such
as mudarabah are wakalah are used to support the implementation of takaful
operations.

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Surplus
comes from many sources such as excessive investment income, favourable
experience in benefits such as mortality benefits, fire etc. However, in family
takaful, the surplus is usually treated separately, namely underwriting
surplus. This is due to that there are often separate models used for
investment, such as mudarabah while underwriting surplus aspects are more
likely to be considered under the wakala model.

 

From
Shari’ah perspective of surplus, underwriting surplus arise from risk funds
which are actually an excess of takaful contributions derived from claims
incurred regardless of any investment gains arising from the contributions
accumulated in the fund. Therefore, the operator does not contribute to any
incremental growth or increase in the value of the funds.

The
Accounting and Auditing Organization for Islamic Financial Institutions
(AAOIFI) is an well-known Islamic international autonomous non-for-profit
corporate body that prepare and provide standards for Islamic financial
institutions and the industry, including takaful. According to AAOIFI, there
are relevant standards allocating for the surplus, namely Financial Accounting
Standards (FAS) No. 13 (Disclosure of Bases for Determining and Allocating
Surplus or Deficit in Islamic Insurance Companies). FAS 13 is intentionally
incorporated to determine and allocate surplus or deficit in Islamic Insurance
Companies. It is required in the standards for Takaful operators to provide a
statement of surplus (or deficit) of the policyholder. The Takaful operators
themselves should disclose the method they use in allocating underwriting
surplus and the shari’ah basis applied in the notes.

 

For
general takaful funds, the underwriting surplus is determined for each takaful
business class after taking into account commissions, unearned contributions,
retakaful, claiming incurred and management expenses. Surplus can be
distributed according to the terms and conditions set by the company’s shari’ah
committees and all takaful operators have to disclose the amount of surplus in
their takaful fund.

 

For
family takaful, the surplus is determined by the annual actuarial valuation of
the family takaful fund. The surplus that can be distributed to the
participants is determined after deducting the claims or benefits paid, retakaful
provisions, commissions, management expenses and reserves. It is distributed
according to the terms and conditions set by the company’s Shari’ah committees.

 

Takaful
company may invest the insurance surplus for the policyholder’s account, if
there is a real provision for this effect in the insurance policy. The
consideration to be paid to the party in such investment related with percentage
of investment profit in mudarabah or commission amount in the case of the
agency, shall be stated in the insurance policy.

 

 

(ii)      What is the Actuarial principles of surplus
distribution?

Takaful
company surplus usually distribute one time per annum at the end of the
financial year. Referring to the ultimate sum of surplus, the surplus to be
distributed should refer to the guidelines given by appointed actuary and
endorse by the board of directors. The guideline prepared by appointed actuary
are based on several factors such as expectations of takaful participants,
regulations has been established by financial regulators, internal policy of
takaful institutions and contracts that have been agreed with the takaful
participants and takaful company as well.

 

The
actuarial principles of the desired characteristics of the takaful surplus
distribution method are stated as follow with assumption the surplus belongs
exclusively to the participants:

 

a.    The element of equitable should be applicable in surplus distribution which means
only the participants who really contribute to profit entitled to get the surplus
distribution. For an equitable surplus distribution, takaful operators may
adopt one of the following three modes which are pro-rata, selective or
off-setting.

 

b. The surplus distribution method must
be acceptable by participants. Participants
have no doubt towards the logic and fairness of the surplus distribution method
prepared by the actuary and adopted by the takaful company.

 

c.  The method of surplus distribution must be simple and easy to govern by takaful
company. At the same time, easy for participants to understand and accept the logic.
It is important to avoid confusion that the participants may encounter if the
method used is too comprehensive.

 

d.  The method of surplus distribution must be flexible, easy to change or modify by
takaful companies if circumstances cause changes in the amount of surplus
available.

 

e.   Distribution of surplus must be consistent and in line with the
actuarial basis for the provision of contributions and liabilities.

 

The determination of surplus
is essentially an actuarial process because it relies strongly on and sensitive
to the actuarial estimation of liability provisions for the business.

 

iii.  In your opinion, what are the factors that
need to be taken into consideration when addressing the practical aspects of
surplus distribution?

 

In the distribution of
surplus, the takaful company should prioritize the interests of takaful
participants as essentially the surplus is belonging them. When it comes to
issues of surplus, the distribution of the surplus must be carried out fairly
and transparent.

 

In implementing surplus administrative
process, the following factors need to be considered and taken into account:

 

a.   Unrealized profits

The surplus is distributed on
income and actual realized profit. This mean the future participants will get more
benefit than the previous generation of participants as unrealized capital
gains are not reflected in previous surplus distributions.

 

b.  
Provision for bad investment

In takaful industry, provision for bad investment
which value has fallen from the value reflected on the purchase will reduce the
takaful surplus. Therefore, takaful company should rewrite corresponding to
that particular provisions to ensure it benefits the future participants.

 

 

 

c.  
Qardhal Hasan

The repayment of the loan, known as
Qardhal Hasan should be given priority over the distribution of surplus to the
participants. This is because Qardhal Hasan is considered as a loan injection
into the takaful fund.

 

d.  
Determination of a fund-based
surplus or product portfolio

While there is a practical limitation to filter
out surpluses to individual participants, efforts must be made to distribute
surpluses in a way that identifies the particular experience of a cohort of
participants who share the same characteristics.

 

The surplus distribution
process needs to identify those who qualify for the surplus sharing. Among the
eligible participants are as follows:

a.     takaful participants who have
never made a claim throughout the year.

b.     takaful participants who claim
less than their risk contribution is paid into the risk pool.

c.    
takaful participants who have made maximum claims are definitely not
entitled.

 

(i)         
Mudarabah Model

 

  The
mudarabah takaful model works on the following basis: takaful operators (known
as shareholders) bear all expenses incurred in operating the business and as a
reward, takaful operators are entitled to share underwriting excess and
investment profits. This is an adjustment of mudarabah Islamic commercial
contracts between takaful operator and participants (or policyholders) who
provide (contribute) the capital. The biggest dissent of this model is
underwriting excess is non-profit. It is excess of premium over claims known as
surplus. This business model is difficult to manage where expenses are fixed
but income (surplus) is not. However, this is a very good model from the perspective
of participants because they do not directly contribute to the operator’s cost.
All their contributions are available to meet claims. Only when there is any
excess of contribution to the claim, the operator will be compensated for the
expenses incurred, and even if only to the extent that the surplus is
sufficient to meet this expense.

 

  Contribution
into the takaful risk pool is deemed as donation which under the Islamic
contract of tabarru’, towards the expected increase in claims. The adoption of tabarru’
and the risk-sharing concept in this risk pool address the Shari’ah’s
fundamental concerns about conventional insurance. However, the tabarru’ will
not be exactly equal with the claim. If tabarru’is inadequate, there will be a
deficit; if it is excessive, there will be surplus. Surplus under the mudarabah
takaful model is crucial for companies to commercially viable. If take away the
surplus sharing then the whole model will collapse.

 

        
However, the mudarabah takaful model is an unpopular choice. In
Malaysia, only two of takaful operators practice this mudarabah model.

 

(ii)       
Wakalah Model

 

  Under
wakalah model, the surplus is referred to the surplus contributed by the
participant into the Risk Fund based on tabarru’ contract. Upon reaching a
financial period, the sum of tabarru’ will not be equal with the amount the
claim. If the tabarru’ amount is less than the sum of claims then the Risk Fund
will be deficit, otherwise the tabarru’ amount exceed the claim then the Risk
Fund will have a surplus.

 

  The
wakala model is the default standard for takaful. Operators charge and carry
out takaful operations. For takaful operators, he makes a profit if wakala fee
exceed expenses.

 

  The
surplus is actually the excess premium paid by the participants, so the surplus
refund can be explained as a experience refund. Once this is accepted, then the
surplus is belongs of the participants.

 

  In
Malaysia, several takaful companies provide shareholders to share in experience
refund. Given that the participants are responsible for the deficit in the risk
pool, it may seem odd that participants should share any excessive contribution
to the shareholders. Many see this as an incentive compensation to the operator
to manage the portfolio well, as evidenced by the surplus. However, whether
this incentive is necessary given since the operators have already received a
fee for underwriting services. As practised in Malaysia, wakala models is a
model where operators only impose their management and distribution costs
through wakala fees, while the profits are from the sharing of any underwriting
surplus. There is also a wakala model where even management expenses and
distribution costs are met from underwriting surpluses and zero fees are charged.
This last extreme wakala model is similar to the mudarabah model. Even some
Shari’ah scholars will also describe mudarabah model as a wakala model with
zero fees

 

  We
can explain this wakala model from the perspective of both participants and
operators. From a participant’s perspective, the decision on the use of a
wakala model whether operators share in excessive premiums or not will depend
on how much higher is the wakala fee he has to pay. It is not always clear that
having a share of the operator in the the underwriting surplus gives the
participants the best value proposition.

 

From operator’s perpective, the wakala
fee is determined as the sum of:

a. Management expenses;

b. Distribution costs include
commissions; and

c. Benefits to the operator

 

Given a
scenario where the surplus and deficit are in the participant’s account and
where the operator’s solvency requirements, hence the capital requirements are
not excessive. It is possible to impose a low wakala fee, thereby benefiting
the participants. If the operator’s profit depends solely on the underwriting
surplus, then such as the mudarabah model, this wakala model will not be
commercially sustainable in the long run.

 

 

 

 

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