Syed Danish Ali

Risk-based capital (RBC) frameworks are designed to ensure insurance providers hold sufficient capital relative to their risk exposure. In conventional insurance, RBC regimes have evolved to protect policyholders and maintain insurer solvency through explicit capital adequacy requirements for various risk categories. Applying these frameworks to Takaful/Islamic insurance based on cooperative risk-sharing is not straightforward. Takaful operations must comply with Shariah (Islamic law) prohibitions on interest and excessive uncertainty, and Takaful has a two-tier structure (participants’ risk fund and the operator’s shareholders’ fund) that differs from conventional insurers. These Shariah constraints and structural nuances pose unique challenges for capital adequacy management in Takaful.

In Part 1 of this article, we had explored the various challenges while following RBC frameworks in takaful context. In Part 2 here, we detail the various solutions to these challenges.

Regulatory Adjustments for Takaful Solvency

Given these challenges mentioned in Part 1, regulators and standard-setters have begun advancing Takaful-specific solvency measures to ensure a fair and stable Islamic insurance sector. The Islamic Financial Services Board has explicitly recommended that capital requirement regulations be developed specifically for Takaful, rather than simply grafting conventional rules onto it. Tailored RBC frameworks would reflect the two-tier fund structure of Takaful, distinguish between risks borne by the participants’ fund and those borne by the operator, and account for the contractual obligations that link them. For instance, Malaysia’s updated Takaful capital framework now requires Takaful operators to maintain at least a 130% CAR at the operator level (shareholders’ fund) in addition to meeting solvency for the participants’ fund1. This ensures the operator has a capital buffer to support the PRF during adversity. Regulators are also looking into stress scenarios unique to Takaful; for example, prolonged non-repayment of qarḍ, or a sudden illiquidity in sukuk markets, to test resilience under Shariah-specific conditions.
Another key regulatory improvement is issuing guidance on fees, surplus, and qarḍ policies to curb practices that undermine solvency. Best practices would require that the wakalah fee (the operator’s management fee) is set at a level proportionate to actual expenses and reasonable profit, rather than an

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arbitrary high percentage. The IFSB survey suggests using expense ratio benchmarks to determine appropriate fee levels2, so that fees are not so high as to guarantee a deficit in the PRF.

Some regulators have already introduced caps on fees; for example, certain jurisdictions impose a maximum wakalah fee percentage for general Takaful, and require actuarial review or approval of fees for family Takaful plans3. Similarly, profit-sharing (mudarabah) ratios on investment returns could be limited or tied to performance, ensuring that participants’ fund retains a reasonable share of investment income. Regulators are also urging stricter rules on surplus distribution: if a participants’ fund has any unpaid qarḍ (i.e. it owes money to the operator’s fund), distributing surplus to participants would be imprudent. Good practice is to mandate that any surplus must first repay outstanding qarḍ, restoring the health of the PRF, before any surplus can be shared. Indeed, some regulatory frameworks explicitly prohibit surplus payouts while a qarḍ balance is outstanding, to prevent the paradox of giving participants a bonus when in fact their fund is in debt. In Pakistan, there is also the regulation that if 3 years have seen qard-e-hasan injections successively, a business remedial plan must be made by the takaful operator that must be adhered to as well. Impairment testing of qard-e-hasan must also be done. The IFSB4 has highlighted that only a minority of jurisdictions currently have clear surplus distribution rules, and it recommends developing such guidelines to prioritize the solvency of the PRF.

Crucially, regulators are revisiting the treatment of qarḍ in capital calculations. An undrawn qarḍ facility, essentially a commitment by the shareholders to fund any future deficit in the PRF, can serve as a form of contingent capital for the participants’ fund. Some solvency frameworks now recognize this by allowing a committed qarḍ facility to count as Tier 2 (supplementary) capital for the Takaful fund, provided that this commitment is formalized and legally subordinated to participants’ claims. In other words, if the operator’s shareholders sign an agreement to automatically cover deficits up to a certain amount, that promise can bolster the perceived capital resources of the PRF (much like a letter of credit or guarantee).

However, to genuinely absorb losses, the qarḍ must behave like true capital: if the Takaful venture fails, that loan would not be repaid until all participant liabilities are met. Not all regulators allow such treatment, but it is gaining traction as a way to acknowledge the operator’s support. On the flip side, regulators are aware that qarḍ is meant to be repaid when a fund returns to surplus, which could perversely drain the fund’s finances again. To avoid an endless cycle of deficit and repayment, some jurisdictions have introduced rules about impairing or writing off qarḍ. If a qarḍ cannot realistically be paid back within a reasonable time (for example, within three years of being granted), regulators may require the operator to write it off, effectively converting that loan into a capital injection for the PRF. In the UAE’s Takaful regulations, for instance, any outstanding qarḍ must be written off after three years if not repaid5.

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This ensures the participants’ fund is not overburdened by a perpetual debt and that the operator’s injected funds truly function as risk-absorbing capital rather than lingering liabilities. Collectively, such regulatory adjustments, from dedicated Takaful capital standards to specific guidelines on fees, surplus, and qarḍ, aim to fortify the solvency of Takaful undertakings while respecting the Shariah principles and mutual ethos that define them.

Strengthening Takaful Fund Resilience

Regulatory reforms alone are not enough; Takaful operators themselves must adopt strategies to strengthen their financial resilience within Shariah constraints. A core principle should be maintaining an adequate participants’ risk fund. Operators need to balance their own profit motive with the solvency of the PRF. This may entail moderating the upfront fees or profit shares they take. For example, instead of charging the maximum allowable wakalah fee, an operator might take a slightly lower fee so that more of each contribution goes into the risk fund to pay claims. The IFSB recommends that Takaful providers aim for fees and profit-sharing ratios that still give shareholders a competitive return on equity, but also leave the PRF with enough funds to at least break even or achieve a small surplus in most years. In practice, this might mean the operator only earns significant profits when the risk fund performs well (aligning incentives toward prudent underwriting and expense management). Some jurisdictions enforce this balance by requiring an actuary to certify that the fee structure will not jeopardize the fund’s solvency, and by scrutinizing expense ratios industry-wide to prevent excessive charges. By ensuring the PRF is not continually drained, operators reduce their own need to provide qarḍ and improve overall stability.

Takaful companies are also exploring Shariah-compliant capital instruments to bolster their capital base. Traditional insurers can issue subordinated debt or other capital market instruments to raise Tier 2 capital; Takaful operators, avoiding interest-based debt, have begun issuing subordinated sukuk (Islamic bonds) for the same purpose. In one recent case, a Takaful firm issued a subordinated sukuk that qualifies as regulatory capital. These instruments are structured on Islamic contracts (such as mudarabah or wakalah), but function similarly to subordinated loans: they are unsecured, long-term, and repayable only after policyholder obligations, often with loss-absorbing features like write-down clauses.

According to the IFSB, only a couple of jurisdictions so far have explicit guidelines to recognize such sukuk as regulatory capital, and only one Takaful operator had utilized this option as of the survey period6. There is considerable room for growth in this area; by issuing sukuk or other Shariah-compliant equity-like instruments, Takaful operators can raise funds to support expansion and solvency without violating Shariah (since profit-sharing or asset-backed structures are used instead of interest-bearing debt). Regulators can facilitate this by clarifying how Islamic capital instruments will be treated under RBC rules (for example, counting a perpetual mudarabah sukuk as Tier 1 or Tier 2 capital if it meets loss absorption criteria). Increasing the availability of “capital bail-out” tools that are Shariah-compliant will help the Takaful industry grow safely, especially as it competes with conventional players.

Another critical area is asset-liability management (ALM) within Shariah constraints. Takaful operators should work to optimize their investment strategy to reduce risk concentration and better match their

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liabilities, even given a limited universe of instruments. This can involve lobbying for more issuance of high-quality sukuk in domestic markets, or using international Islamic capital markets to diversify holdings.

In jurisdictions where government or central bank sukuk are available, Takaful companies can invest in them as near-risk-free assets akin to conventional treasury bonds; these carry low capital charges and provide stable returns. Where local supply of sukuk is insufficient, regulators could permit greater investment in foreign currency sukuk or Islamic funds, with appropriate hedging of currency risk, to improve diversification and duration matching. Takaful firms have expressed the need for more long-term Shariah-compliant instruments to match family Takaful (life) liabilities.

In the interim, operators can manage liquidity by utilizing Islamic money market tools, such as commodity murabahah deposits or Islamic repurchase agreements, to avoid holding excessive idle cash. By improving ALM, a Takaful operator not only reduces its risk (and thus capital requirement) but also potentially improves returns for participants, creating a virtuous cycle of solvency and performance.

Finally, Takaful operators should implement robust risk management and internal capital assessment processes tailored to their model. This includes performing an Own Risk and Solvency Assessment (ORSA) or similar exercise that considers scenarios specific to Takaful. For example, management should model what happens if the participants’ fund continues to run deficits for multiple years; how much capital would the operator need to inject, and can it afford it? Or if equity markets downturn and sukuk are scarce, how will the fund cope with claims?

By identifying such vulnerabilities, operators can plan mitigants in advance, such as arranging contingent funding lines (perhaps from parent companies or Islamic banks) or adjusting product pricing and benefits to control losses. Strong corporate governance is also essential: a Shariah board should be actively overseeing compliance to prevent non-compliance incidents, and finance teams should transparently report the financial status of the PRF versus the shareholders’ fund. In essence, a culture of prudent risk- sharing needs to prevail, where the operator’s profitability is aligned with participants’ fund health.

Conclusion

Maintaining solvency in Takaful requires a delicate balance between upholding Shariah principles and achieving the financial rigor of modern insurance regulation. By tailoring RBC frameworks to account for Takaful’s cooperative structure; and by Takaful operators themselves exercising disciplined financial management; the Islamic insurance industry can attain solvency standards on par with conventional insurers. The challenges, whether in governance, investment, or regulation, are significant but not insurmountable. With collaborative effort from regulators to provide clear, Shariah-compliant guidelines, and from operators to innovate within those guidelines, Takaful can continue to grow as a fair, safe, and stable sector without compromising its foundational Islamic principles.

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