Syed Danish Ali
Actuarial consultant, IFRS 17, RBC and Takaful expert.
Certified in predictive analytics (iCAS)

Takaful, as a Shariah-compliant alternative to conventional insurance, operates within a distinct framework that affects its pricing dynamics and financial interactions. Unlike conventional models, Takaful demands a separation between policyholders’ funds and shareholders’ funds, ensuring ethical financial management and compliance with Islamic principles. This distinction influences various aspects, including Qard Al Hasanah provision, surplus distribution, solvency considerations, and IFRS17 financial reporting.

The Role of Qard Al Hasanah in Takaful Stability

A defining feature of the Takaful system is the provision of Qard Al Hasanah—an interest-free loan from shareholders to policyholders’ funds in times of deficit. Key characteristics include:

– Permanent Availability: Legal frameworks ensure that Qard Al Hasanah remains available, up to the shareholders’ capital and surplus limits.
– Financial Isolation: Shareholders must take full provision for Qard Al Hasanah in their accounts to prevent financial instability.
– Neutral Impact on Equity: As Qard Al Hasanah deductions occur from net profits, they do not disrupt the company’s overall financial position or its solvency assessments.

However, excessive reliance on Qard Al Hasanah can signal deeper financial inefficiencies, particularly if deficits persist over multiple years, ultimately affecting the solvency margin test. Therefore, strategic pricing adjustments are essential to avoid repeated deficits.

Pricing and the Wakala Fee Structure

Pricing within Takaful is uniquely linked to the Wakala model, which determines the fee structure and financial flows between policyholders and shareholders. While premium collections may be adequate, high Wakala fees can strain policyholders’ funds, leading to successive deficits. This can trigger a cycle where repeated Qard Al Hasanah provisions create solvency challenges.

Another critical factor is IFRS17 reporting, where:

– Wakala fees are treated as fees under IFRS15, requiring immediate recognition rather than gradual earning like conventional earned premiums.
– Surplus allocation must be carefully managed as an expense, influencing pricing structures.
– Liquidity management becomes essential—adverse claim situations may require liquid investment adjustments, affecting Wakala fees.

Pricing and Financial Solvency

Inadequate pricing places pressure on investment assets, forcing insurers to sell holdings—potentially at a loss—to meet claim obligations. Long-term deficits erode solvency, leading to capital injections. Under-pricing across multiple years can result in significant solvency risks if these gaps aren’t addressed.

Underwriting losses can be compensated by investment income, but excessive reliance on investment returns rather than underwriting discipline weakens financial resilience. Takaful firms must meticulously assess underwriting performance separately from investment returns due to the dual-fund structure.

Reserving and Regulatory Compliance

Under conventional insurance, Premium Deficiency Reserves (PDRs) under IFRS4 signal under-pricing concerns. The introduction of IFRS17 replaces PDRs with loss components, which now incorporate risk adjustments alongside underwriting results.

For Takaful, the equivalent mechanism is the Contribution Deficiency Reserve (CDR). However, CDR is triggered more easily than PDR due to differences in calculations:

– Conventional PDR considers 55% of expenses, ensuring limited deficits.
– Takaful CDR, however, accounts for 100% of Wakala fees, making it more susceptible to activation.

This distinction places greater emphasis on disciplined underwriting and risk management within the Takaful industry.

Case Studies and Real-World Examples

Case Study: Takaful International – Bahrain vs. Islamic Insurance Company – Sudan

A comparative study of two Takaful companies in Bahrain and Sudan highlights key differences in financial reporting and operational models.

– Bahrain’s Takaful International follows Mudharabah and Wakala models, ensuring transparency and compliance with IFRS standards.
– Sudan’s Islamic Insurance Company primarily operates under the Wakala model, but lacks detailed financial disclosures, impacting investor confidence.

This case study underscores the importance of clear financial reporting and regulatory alignment in maintaining solvency and trust within the Takaful industry.

Example: Liquidity Challenges in Takaful Pricing

A Malaysian Takaful operator faced liquidity issues due to under-pricing and excessive Wakala fees. Successive Qard Al Hasanah provisions were required to cover policyholder deficits, leading to solvency concerns. The company had to restructure its pricing model, reducing Wakala fees and improving underwriting discipline to restore financial stability.

Example: IFRS17 Implementation and Transparency

A leading Takaful provider in the UAE adopted IFRS17, revealing previously hidden underwriting losses. The new reporting standards forced the company to reassess its pricing strategy, ensuring better risk management and financial sustainability.

Concluding Thoughts

Effective pricing in Takaful requires continuous financial monitoring, surplus planning, and solvency management. Successive Qard Al Hasanah provisions, under-pricing, and liquidity pressures can jeopardize long-term sustainability if not addressed proactively. As IFRS17 demands enhanced transparency in financial reporting, the Takaful industry must embrace underwriting discipline, optimize Wakala fees, and align financial structures with ethical principles to maintain stability and growth.

By refining pricing models and ensuring robust solvency frameworks, Takaful operators can strengthen trust and confidence within the ethical finance sector, reinforcing its pivotal role in Shariah-compliant risk protection.