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

Basel 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 and
economic benefits of modern insurance coverage, in a form which is consistent with religious
beliefs, 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 of
countries 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 still
facing 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 development
of 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 high
transparency 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 one’s 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[ CITATION Get92 \l 1033 ]. They also need old age and child care, problems that have
become more acute[ CITATION Get92 \l 1033 ].

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.

1.1 General Concept of Takaful

Islam 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[ CITATION Iqb05 \l 1033 ]. This applies to the concept of
Insurance.

A Shariah- based insurance policy would never involve the unlawful elements 1. 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[ CITATION Bil03 \l 1033 ].

1
This 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[ CITATION Raz09 \l 1033 ].

1.2 What 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 ta’awun 4
and tabarru’ 5 whereby the risk that associated with it is shared among a group of people
voluntarily[ CITATION Ism10 \l 1033 ].

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[ CITATION Ven06 \l 1033 ].

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”[ CITATION Mal10 \l 1033 ].

Currently in Malaysia, Takaful is being practiced not by insurance agents or brokers, but
directly by Syarikat Takaful Malaysia6 through the desks of Bank Islam Malaysia
branches and sixteen Tabung Haji7 offices[ CITATION Ven06 \l 1033 ].

2
An Arabic term which refers to what we called in English: Inheritance
3
An Arabic term which denotes a Bequest
4
It means Mutual assistance
5
Gift, donation
6
First established Takaful company in Malaysia
7
Tabung 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 Insurance

The 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 Takaful

This is an investment programme8 to provide halah investment returns to the
participant as well as mutual financial aid. Individuals participate to save
regularly 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.
The plan may be taken for terms of ten, fifteen or twenty years. Participants must
8
This 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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 be between the ages of eighteen and fifty years, and the plan must mature before
the participant reaches sixty years.

1.3 Role of Takaful Operators/Agencies in Islamic Financial Institutions

The Ultimate Aim of the Takaful Agency Members 9 is 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[ CITATION Yap09 \l 1033 ] . It is also mentioned by the author about the
various briefs of the Organizations and Functions of the Takaful Agency.

(a) Takaful Agency Manager 11

 Overall expansion of the Takaful agency’s 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

(b) Takaful Unit Manager12

9
The range starts from Agency Manager, Unit Manager, Specialist and Agents.
10
Sheikh Yusof Al-Qadarawi is a public intellectual and immense international influence.
11
This is also known as Group General Manager.
12
Also known as Agency Manager.

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  Markets and sells the Takaful plans
 Develops a huge customer and client base
 Services this client base
 Develops and build up specific market
 Recruits, train and motivate Takaful agents
 Takes on a leadership role for the Industry

(c) Takaful Specialist13

 Markets and sells the Takaful plans
 Develops a huge customer and client base
 Services this client base
 Specializes in certain Takaful markets

(d) Takaful Agent 14

 Markets and sells the Takaful plans
 Develops a huge customer and client base
 Services this client base

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 [ CITATION Yap09 \l 1033 ] . They should work in
unison towards the economic success of both the agency and their respective family [ CITATION
Yap09 \l 1033 ].

1.4 Sources of Law Affecting Takaful

13
Also known as Charted Takaful Underwriter.
14
Acts as Consultant.

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An 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 [ CITATION
Bil01 \l 1033 ].

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[ CITATION Fis08 \l 1033 ]. The belief in one
God is the universal principles that offer harmony and unity to all humanity [ CITATION
Fis08 \l 1033 ]. 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 [ CITATION
Fis08 \l 1033 ].

There are indeed a number of Divine injunctions in the Holy Quran, which justify the
validity of an insurance contract[ CITATION Bil01 \l 1033 ]. The contract of insurance
contains the elements of mutual cooperation 17[ CITATION Bil01 \l 1033 ]. It is a binding
promise, which binds both the insurer and the insured based on the general principle of
contract18[ CITATION Bil01 \l 1033 ] . 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[ CITATION Bil01 \l 1033 ].

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[
CITATION Bil01 \l 1033 ].

15
Also known as Sunnah.
16
Analogical sources such as Qiyas, Istihsan and Ihtisab.
17
See Al-Quran, Surah al-Maidah, 5:2.
18
See Al-Quran, Surah al-Maidah, 5:1.
19
See Al-Quran, Surah al-Baqarah, 2:201.
20
See 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
don’t 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[ CITATION Ket081 \l 1033 ].

Another example was the Prophet’s actions during the Hijra21. Feeling danger, he hid in a
cave instead of going straight to Medina[ CITATION Ket081 \l 1033 ]. 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[ CITATION Ket081 \l 1033 ].

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 Arab’s 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 of Huzail. Hence, this approved practice stand a valid
justification for the validity of insurance.

21
The migration of Muhammad s.a.w and his followers to Medina in 622AD.
22
Al-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

1.5 Features of Takaful

An insurance practice under Islamic teachings possesses certain fundamental

characteristics upon which an insurance contract is to be held valid [ CITATION Bil01 \l
1033 ]. 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

23
Every 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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 1.6 Scope of Takaful Contract

Generally, 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 [ CITATION Bil01 \l 1033 ]. For instance,
Allah (s.w.t) prohibits any kind of accumulation of profit and wealth by way just of
unjust enrichment27[ CITATION Bil01 \l 1033 ].

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 [ CITATION
Bil01 \l 1033 ].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[ CITATION Bil01 \l 1033 ].

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

to the principle of fixed-rate interest[ CITATION Bil01 \l 1033 ]. 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 state
authority[ CITATION Bil01 \l 1033 ].

27
This 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
stakeholder’s rights, including those of policyholders[ CITATION Arc09 \l 1033 ].

2.0 Disclosure Requirements, Contents and Scope

Transparency and disclosure28 provisions serve two purposes. On the one hand, they are a
prerequisite for comparisons of products and services and they facilitate informed choices of
consumers.

2.1 Multiple fees and charges

In the Gulf region, the Takaful Operator benefits from a high volume of underwriting,
due to[ CITATION Arc09 \l 1033 ]:

(a) An upfront payment in the first year, calculated as a percentage (30-60%) of the first
year’s 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[ CITATION Arc09 \l 1033 ] . 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 [ CITATION Arc09 \l 1033 ] . These
retained profits can be invested again with a profit share for the Takaful
Operator[ CITATION Arc09 \l 1033 ].

28
On 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.

Page 11 of 22
 Most components of the remuneration of the Takaful Operator are directly proportionate
from the volume of Takaful contributions collected from the participants [ CITATION
Arc09 \l 1033 ]. 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 [ CITATION
Arc09 \l 1033 ].

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 [ CITATION Arc09 \l
1033 ].

2.2 Commissions (in family Takaful)

In family Takaful, the commission to be paid to the distribution partner poses a major
problem[ CITATION Arc09 \l 1033 ]. 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 [
CITATION Arc09 \l 1033 ]. The commission payment may well exceed the total amount of
the participant’s 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 it’s for the underwriting elements only[ CITATION Arc09 \l 1033 ]. Therefore it
looks excessive at the participant’s part29.

An alternative to surplus sharing could be to pay the commission not upfront but pro rata
over the term of the contract[ CITATION Arc09 \l 1033 ]. 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[ CITATION Arc09 \l 1033 ].

In order to overcome this, Shariah scheme for the transformation of future pro rata
payments into an upfront lump sum payment will be initiated[ CITATION Arc09 \l 1033 ].
29
This may not be sufficient to cover what is due to the distribution partner.

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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[ CITATION Arc09 \l 1033 ]. 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[ CITATION Arc09 \l 1033 ].

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[ CITATION Arc09 \l 1033 ]. One of its objectives is to address
the specificities of Islamic insurance companies, especially with respect to policyholder’s rights

in underwriting funds and the movements in these funds[ CITATION Arc09 \l 1033 ].

3.1 Future Financial Reporting Trends

The Takaful stakeholders have access to better-quality financial information from more
sophisticated markets and expert to obtain similar information from the Takaful
markets[ CITATION Arc09 \l 1033 ] . These increasing expectations are putting more pressure
on Takaful companies to disclose voluntarily financial information that they would not
otherwise have disclosed[ CITATION Arc09 \l 1033 ].

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
reporting of Takaful companies to specifically address the disclosure of policyholder’s
rights in accumulated funds[ CITATION Arc09 \l 1033 ].

Below is the AAOIFI standards that deal with Islamic insurance companies were issued
in 1999 and 2000:

30
AAOIFI 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.

Page 13 of 22
 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[ CITATION Arc09 \l 1033 ]:

(a) Proper application of the financial reporting framework is enforced by the regulators
and the markets31.
(b) Harmonization and proper communication of Shariah supervisory board’s decisions
and fatwa32.
(c) Enhanced disclosures on policyholder’s funds, allocation of surplus to policyholders,
and income from prohibit transactions33.
(d) Robust corporate governance rules are implemented34.

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

 Use of internal models (instead of prescribed factors)

 Profit Recognition at inception, which considered at Service Margin based on the service
given.

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 policyholder’s 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.
34
This is to ensure adequate disclosure of relevant information about the company’s investment objectives and
policies, and operational guidelines that govern the relationship between the shareholders and the policyholders.

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  Risk Base Capital for Takaful in Malaysia
 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 Takaful

Operators may lose out in comparison with conventional insurers [ CITATION Ism10 \l

1033 ]. 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 [ CITATION

Ism10 \l 1033 ].
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[ CITATION Ism10 \l 1033 ]. 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[ CITATION Ism10 \l 1033 ].

Another Issue with respect to taxation is the payment of zakat 35, the payment of zakat should not
be given full rebates, therefore Takaful Operators would be disadvantaged compared to
insurers[ CITATION Ism10 \l 1033 ]. 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[ CITATION Ism10 \l 1033 ].

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 [ CITATION Ism10 \l
1033 ]. 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[ CITATION Ism10 \l 1033 ].
35
Some contemporary Scholars advocate that the payment of zakat is not considered as tax-deductible expense.

Page 15 of 22
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 [ CITATION
Ism10 \l 1033 ]. 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[ CITATION Ism10 \l 1033 ].

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[ CITATION Wik10 \l 1033 ] . Internationally, the Basel Committee on Banking Supervision
housed at the Bank for International Settlements influence each country's banking capital
requirements[ CITATION Wik10 \l 1033 ]. In 1988, the Committee decided to introduce a capital
measurement system commonly referred to as the Basel Accord[ CITATION Wik10 \l 1033 ] . 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 [ CITATION Wik10 \l 1033 ] . 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[ CITATION Wik10 \l
1033 ]

In June 2006, Basel Committee had come up with a revised Banking Supervision for Insurance
entities as the mentioned below[ CITATION BIS06 \l 1033 ]:

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
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

Page 16 of 22
and liabilities, as well as third party capital investments in an insurance subsidiary 36[ CITATION
BIS06 \l 1033 ].

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[ CITATION BIS06 \l 1033 ].

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 bank’s
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 [ CITATION BIS06 \l 1033 ]. 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 [ CITATION BIS06 \l 1033 ] . 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[ CITATION BIS06 \l 1033 ].

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

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.

Page 17 of 22
subject to an alternative group-wide approach, are themselves adequately capitalized to reduce
the possibility of future potential losses to the bank [ CITATION BIS06 \l 1033 ] . 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 bank’s capital [ CITATION
BIS06 \l 1033 ].

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[ CITATION Arc09 \l 1033 ].
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.

Risk Base Capital requirements are mainly [ CITATION Yah10 \l 1033 ]:

Page 18 of 22
 • 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[ CITATION Arc09 \l 1033 ]. 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[ CITATION Arc09 \l 1033 ].

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, should
also 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 [ CITATION Arc09 \l 1033 ] . 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 [ CITATION Arc09 \l 1033 ].

37
Thus, 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.

Page 19 of 22
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[ CITATION Arc09 \l 1033 ].

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[ CITATION Kab07 \l 1033 ]. These three models bring the principles of cooperation,
solidarity and brotherhood that underlie Takaful[ CITATION Kab07 \l 1033 ].

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[ CITATION Kab07 \l 1033 ].

Proper regulation and supervision of banks and financial institutions is also important for
financial efficiency and stability[ CITATION Kab07 \l 1033 ]. 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 [ CITATION Kab07 \l 1033 ].
Therefore, the need for special guidelines for the regulation and supervision of Islamic banks has
long been felt[ CITATION Kab07 \l 1033 ].

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 [ CITATION Kab07 \l 1033 ] . Its
mandate 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[ CITATION Kab07 \l 1033 ] . For example, the IFSB will promote the

38
Subprime crises had been regarded as a cause which leads to the financial instability.
39
The three alternatives of Takaful Models are, Wakala, Mudaraba and Tijari.
40
Define broadly to include banking, capital market and insurance.

Page 20 of 22
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[ CITATION Kab07 \l 1033 ]. This complements that of the Basel
Committee on Banking Supervision, International Organization of Securities Commissions and
the International Association of Insurance Supervisors[ CITATION Kab07 \l 1033 ].

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.

Bibliography

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AVIVA.

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

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

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