Takaful and Conventional Insurance - Essay Example

Takaful and Conventional Insurance Takaful and Conventional Insurance Introduction Takaful is often inaccurately interpreted as an Islamic variant of cooperative or mutual insurance; there are significant differences between the two (Wahab, 2006). This paper illustrates this point by first explaining the differences between conventional and cooperative insurance. The paper then compares and contrasts cooperative insurance and Takaful, with special emphasis on the nature of the underlying contract in each case. Differences between Conventional Insurance and Mutual Insurance Conventional or commercial insurance entails an insurer entering into an agreement with a policyholder. The insurer undertakes or commits to pay the policyholder an amount of money or its equivalent upon the taking place of the event specified in the agreement (Ghifari, 2003). Usually, there is some uncertainty about the specified event. The uncertainty could arise from the fact that although the event must occur at some point in the course of nature, its timing is unknown. An example is death. Even though every rational human being knows that they will die one day, they do not know that day. The uncertainty about the event may also stem from the fact the occurrence of the event is dependent on accidental causes and the event may, therefore, never occur. An example is a car accident whose occurrence depends on a number of factors such as the mental state of the driver. If a driver is always sober and, therefore, in the right state of mind, the accident against which the driver is insured may never occur on account of the driver’s state of mind. Thus, uncertainty is one of the features of commercial insurance. The main difference between commercial insurance and mutual or cooperative insurance is in the way that the company providing insurance services is owned (Gonulal, 2013). In commercial insurance, shareholders who have purchased the company’s shares while with mutual insurance own the company, the policyholders own the entire company, except in France where the policyholders are said to “control” the company. Any profits that a mutual insurance company makes are shared among the policyholders in the form of dividends. Alternatively, a policyholder’s dividends may be retained so that the policyholders pays reduced or no dividends in the future. The fact that the owners and customers of a mutual insurance company are the same, it is assumed that mutual insurance companies possess certain advantages over their commercial counterparts. For instance, it is assumed that that the former promote the interests of their members better than the latter. Also, it is speculated that because mutual insurance companies do not have to pay dividends to their members like commercial companies, they can retain greater proportions of their profits and use them to enhance future profitability. However, without empirical evidence to support them, the supposed benefits of mutual insurance must be discounted. Another difference between conventional insurance and cooperative insurance is the overriding principle that underlies each. Whereas conventional insurance is driven by the maximisation of profit, cooperative insurance is driven by the principle of bearing one another’s burden, a principle that cuts across and is taught by many religions of the world (Gonulal , 2013). Thus, the members’ premium contributions are seen as a financial pool out of which the mutual insurance company improves the financial well-being of its members. The company does this by restoring a member who suffers a financial loss, as a result of the occurrence of an event, to their initial position. By securing the financial well-being of their members, mutual insurance companies believe that they contribute to the well-being of whole communities. The one criticism of commercial insurance that has endured is that insurance companies make money by failing to provide a service to their clients(Gonulal, 2013). Put another way, insurance companies make profits by collecting the greatest amounts of premiums possible and paying out the least amount possible in benefits. Of course, a tough balancing act is required; the insurance company that becomes known for not for not paying out claims could lose all its customers. By contrast, to the greatest extent possible, a mutual insurance company wants its payouts to equal premium collections. At the close of the year, any surplus premiums (representing profit) are either returned to the customers or held and used to adjust future premiums. Given the general dissatisfaction with conventional insurance tendency of insurers making a profit by not providing a service and the potentially liberating mutual insurance alternative, it is unclear how the latter lags behind the former. An Internet research reveals that there is very limited scholarly literature on the subject of mutual insurance. Access to capital is another area of difference between the two strands of insurance(Gonulal, 2013). Commercial insurance companies have relatively easier access to credit facilities from commercial banks and other sources than their mutual insurance counterparts. Two important aspects influence the decision of a commercial bank to lend or not lend to a firm: the availability of collateral and the firm’s profitability. The latter is indicative of the firm’s ability to repay the loan while the former gives the bank some assurance that even if the firm ceases to be profitable with the loan outstanding, the bank can still recover its money by liquidating the asset offered by the firm as collateral against the loan facility. Given mutual insurers’ altruistic values and their insistence to paying out all premiums collected, they are less profitable than their commercial counterparts. Their low profitability may imply that mutual insurers have to collateral with which to access credit, let alone to repay it. In response to the funding challenge, mutual insurers, particularly those in the West, have resorted to the rather complicated strategy of demutualisation (Gonulal, 2013). In simple terms, the strategy involves separating the owners and clients of mutual insurers. The creation of mutual holding companies is one the ways through which mutual insurers demutualised. First introduced in Iowa, United States in 1995, the technique has since spread and been embraced by a number of American mutual insurers including Prudential, Guardian, New York Life and Metropolitan Life. A mutual holding company is a great idea to the average policyholder: a more efficiently managed, flexible, competitive, and profitable company (Banstetter, et al., 1997). To critics, however, mutual holding companies represent “bait-and-switch” schemes(Rambek, 2001). The bait comes at the point when a potential client is approached; mutual life insurers in particular like to tell people that by buying a policy, they become “owners” of the company. Then, when the time to demutualise comes, the "owners" are promised interests in the new mutual holding company. According to critics, a policyholders interest in a mutual holding company is "air underneath a pea-less shell: it is a rip-off. Only company executives benefit. These allegations, specifically leveled against Liberty Mutuals proposed mutual holding company back in 2001, are weighty and call for further scholarly investigation. Mutual Insurance and Takaful There is no universal definition of how a takaful operation works just as there is no standard way in which mutuals operate. Rather, regulations have played a key role in shaping the practice of takaful in different jurisdictions (Gonulal, 2013). Like Islamic finance, Takaful is governed by the Islamic commercial law that is distinct from laws that govern belief in and the worship of God. Takaful markets are scattered all over the world, but are more concentrated in Islamic countries the two largest of which are Malaysia and Bahrain (Central Bank of Malaysia, 2000). Takaful markets have grown significantly in recent years. For instance, takaful premiums reached US$8.3 billion in and 2010 and were projected to hit the US$12 billion mark by 2012 (Gonulal, 2013). The growing importance of Takaful has generated interest among Islamic scholars. The work of these scholars has centered on the various models of insurance and what lessons Takaful can learn from them. The following two sections discuss the similarities and differences between Takaful and cooperative or mutual insurance. Similarities Most takaful companies around the world embrace the principle of mutuality held mutual insurers (Central Bank of Malaysia, 2009). There are two dimensions to mutuality: resource pooling and risk-sharing or solidarity. The mutuality principle underpins Takaful contracts unlike in conventional insurance where the burden of risk is transferred to the insurer who bears the loss provided that the loss is in line with the contract entered into by the insurer and the policyholder. Under the resource pooling model, individuals contribute their premiums to a common for the purpose of compensating their members who suffer financial losses as the result the result of occurrence of an insurable risk. An insurable risk is an event that is likely to result in a financial loss if it occurs and one that affects the policyholder, also called the insured. The premiums paid by each person should, as much as possible correspond to the level of risk that they bring with them. Thus, in a life insurance scheme, for instance, a member aged 60 is likely to pay higher premiums than the one aged 30; it is assumed that even though any person can die at any age, death is more imminent for an aging person than a young person, keeping all other factors constant. Similarly, a mine worker is at a greater risk of personal injury than a school teacher and is, therefore, likely to pay higher premiums. Solidarity is about loss-sharing (Fisher & Taylor, 2000). Mutuality is modeled along the family as the fundamental unit of the family. Just as the members of a family share losses, so do the members of a mutual organisation. The more the members, the less the loss each member bears. When a member of a mutual insurance company is involved in a road accident, for instance, and their car is damaged, the members will share the loss involved among themselves, the loss being the sum of money needed to repair the car. The members will share the loss out of the common pool to which they donate in the form of premiums. By contrast, a commercial insurance company will see the situation as requiring the company to settle the claim raised by the client. The settling of the claim eats into the companys profits. Differences While observing the principles of mutuality, many takaful companies around the world raise their capital through the issue of shares (Ajmal, 2001), a phenomenon that make some conservative Islamic scholars frown. Like the banking industry, the insurance industry is heavily regulated the world over. Regulators set stringent minimum requirements with which insurance companies must comply. Such requirements include minimum capital, sound management systems and ongoing solvency margin. The initial capital requirements are meant to ensure that insurance firms can meet the costs of running the operation before they can collect any premiums. Solvency capital requirements are designed to ensure that firms can pay all the claims that may arise in any given financial year. A start mutual insurance firm can rarely meet such strict capital requirements. Moreover, as soon it is established, an insurance firm needs to generate a large client portfolio in order to a claims record with statistical credibility. It is for these reasons that Takaful companies must look beyond members’ contribution hence the issuance of shares. Another difference between Takaful and mutual insurance is in the way the two allocate risks. There are at least three types of risk associated with insurance: expense, operational and underwriting risks(Hussain, 2011). Transparency demands that a Takaful company discloses its fees and income in the takaful contract. It is out of the fees or income that the takaful company meets the day-to-day expenses of running the company and pays dividends to its shareholders. In a takaful that operates separate financial reporting systems for shareholders and participants, the shareholders bear the expense risk. In a mutual insurance company, the policyholders bear the expense risk and the risk affects the profits (or dividends) paid to the members. Shareholders of a Takaful company employ the managers of the company who are charged with the proper running of the company (Al Janahi & Weir, 2005). As a result, the shareholders also bear the operational of the business. The fees (or income) received from the participants for the purpose of running the business should, therefore, be used to compensate the shareholders for bearing the risk. Again, the maintenance of separate balance sheets for the participants and shareholders makes it possible for operational risk to be quantified and the minimum capital requirements maintained. In a mutual insurance company, all the policyholders, being the owners of the company, bear the operational risk. The fragmented equity structure of a mutual insurance firm often gives rise to weak management and raises the operational risk. Underwriting risk is the risk associated with undertaking to compensate a policyholder in the event that they suffer the risk specified in the insurance contract (Ali, 1989). In conventional insurance, the insurer undertakes to pay a claim as and when it occurs(Gonulal, 2013). In return, the policyholder agrees, in the contract, to pay regular premiums to the insurer. This arrangement transfers the risk from the policyholder to the insurer. Either the insurer commits to a speculative venture that will make a profit or loss depending on whether or not the risk insured against occurs. In a mutual insurance firm, the policyholders share the underwriting risk among themselves. The policyholders manage real risks by indemnifying each other using the premiums they have pooled. A real risk is one where real loss has occurred and real loss occurs when the event that is insured against occurs. Takaful operations operate risks in the same way. However, there exists an important difference in the way a mutual operation and takaful operation each manage deficits. A deficit occurs when the value of claims lodged in a given period exceeds the value of premiums collected in the same period. In Takaful, the shareholders are obliged to extend an interest-free loan to the operations risk pool to cover the deficit (Gait & Worthington, 2008). The loan is repaid from future surpluses in the risk pool. Such a facility does not exist in a mutual operation as there are no shareholders. The mutual operation may raise additional funds externally using a number of suitably structured debt instruments, albeit at a cost and greater uncertainty. Prior to the 2008 financial crisis, several mutual insurance companies in the West demutualised (Gonulal, 2013). The demutualisation was in part driven by the need of policyholders to cash in on orphan estate – surpluses generated by previous policyholders that theoretically cannot be shared among existing policyholders unless the operation demutualises (Aris, 2004). As takaful is relatively new, few takaful operations have orphan estates, but where an unclaimed surplus exists, sharia requires that it be given to charity. However, this provision applies only when an operation is winding up, not while it exists. Another glaring difference between a mutual and a takaful operation is the need for the takaful operation to establish and run a Sharia advisory board that is charged with ensuring the operation is sharia compliant. Conclusion While there exist many differences between conventional and mutual insurance, the main difference is in the way each is owned (Billah, 2003). Shareholders own a commercial insurance operation whereas the policyholders own a mutual operation. Consequently, the shareholders of a commercial operation bear the underwriting risk and other risks associated with running the operation. In a mutual operation, those risks are borne by the policyholders. In comparing and contrasting mutual and takaful operations, both operate on the principle of mutuality that requires the pooling of resources and sharing of risks. While the risks are the same in both operations – operational, expense, underwriting and investment risks, the difference is in the way those risks are shared. In a mutual operation, the policyholders bear all the risks; in a takaful operation, the risks are shared between the participants and the shareholders. References Ajmal, B., 2001. Takaful Industry: Global Profile and Trends, London: Institute of Islamic Banking and Insurance. Al Janahi, A. & Weir, D., 2005. Alternative Financial Rationalities in Managing Corporate Failure. Managerial Finance, 31(4), pp. 34-45. Ali , K., 1989. Principles and Practices of Insurance under Islamic Framework. Insurance Journal , pp. 29-39. Aris, Y., 2004. Takaful- An Option to Conventional Insurance: A Malaysian Model, Mara: University of Technology. Branstetter, R., Carmichael, D., Dunham, W. & Smallenberger, J., 1997. The Mutual Holding Company: A New Structural Option, Noblesville: The Association of Life Insurance Counsel. Billah, M., 2003. Islamic and Modern Insurance (Principles and Practices). 1st ed. Kuala Lumpur: Ilmiah Publishers. Central Bank of Malaysia, 2000. 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