In takaful, the surplus is definedas an asset minus the liability of takaful risk fund. Surplus exists due to thedifference between actual experience and price assumptions.
Total of surplusdepends on how assets and liabilities of the takaful fund are assessed. Surpluscan 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 basedon the fact that takaful contracts are generally built on tabarru’ (donation)and ta’awun (help-assist) along with mutual consent between parties. Tabarru isa key principle that underlies takaful products. Other shari’ah principles suchas mudarabah are wakalah are used to support the implementation of takafuloperations. Surplus comes from many sources suchas excessive investment income, favourable experience in benefits such asmortality benefits, fire etc.
However, in family takaful, the surplus isusually treated separately, namely underwriting surplus. This is due to thatthere are often separate models used for investment, such as mudarabah while underwritingsurplus aspects are more likely to be considered under the wakala model. From Shari’ah perspective ofsurplus, underwriting surplus arise from risk funds which are actually anexcess of takaful contributions derived from claims incurred regardless of anyinvestment gains arising from the contributions accumulated in the fund.
Therefore, the operator does not contribute to any incremental growth orincrease in the value of the funds.The Accounting and AuditingOrganization for Islamic Financial Institutions (AAOIFI) is an well-known Islamicinternational autonomous non-for-profit corporate body that prepare and providestandards for Islamic financial institutions and the industry, includingtakaful. According to AAOIFI, there are relevant standards allocating for thesurplus, namely Financial Accounting Standards (FAS) No.
13 (Disclosure ofBases for Determining and Allocating Surplus or Deficit in Islamic InsuranceCompanies). FAS 13 is intentionally incorporated to determine and allocatesurplus or deficit in Islamic Insurance Companies. It is required in thestandards for takaful operators to provide a statement of surplus (or deficit)of the policyholder. The takaful operators themselves should disclose themethod they use in allocating underwriting surplus and the shari’ah basisapplied in the notes. For general takaful funds, theunderwriting surplus is determined for each takaful business class after takinginto account commissions, unearned contributions, retakaful, claiming incurredand management expenses. Surplus can be distributed according to the terms andconditions set by the company’s shari’ah committees and all takaful operatorshave to disclose the amount of surplus in their takaful fund.
For family takaful, the surplus isdetermined by the annual actuarial valuation of the family takaful fund. Thesurplus that can be distributed to the participants is determined afterdeducting the claims or benefits paid, retakaful provisions, commissions, managementexpenses and reserves. It is distributed according to the terms and conditionsset by the company’s Shari’ah committees. Takaful company may invest the insurancesurplus for the policyholder’s account, if there is a real provision for thiseffect in the insurance policy. The consideration to be paid to the party insuch investment related with percentage of investment profit in mudarabah orcommission amount in the case of the agency, shall be stated in the insurancepolicy. Takaful company surplus usually distribute one timeper annum at the end of the financial year. Referring to the ultimate sum ofsurplus, the surplus to be distributed should refer to the guidelines given byappointed actuary and endorse by the board of directors.
The guideline preparedby appointed actuary are based on several factors such as expectations oftakaful participants, regulations has been established by financial regulators,internal policy of takaful institutions and contracts that have been agreedwith the takaful participants and takaful company as well. The actuarial principles of the desiredcharacteristics of the takaful surplus distribution method are stated as followwith assumption the surplus belongs exclusively to the participants: a. The element of equitable should be applicable in surplus distribution which meansonly the participants who really contribute to profit entitled to get the surplusdistribution. For an equitable surplus distribution, takaful operators mayadopt one of the following three modes which are pro-rata, selective oroff-setting. b.The surplus distribution method must be acceptableby participants. Participants have no doubt towards the logic and fairness ofthe surplus distribution method prepared by the actuary and adopted by thetakaful company. c.
The method of surplus distribution mustbe simple and easy to govern bytakaful company. At the same time, easy for participants to understand andaccept the logic. It is important to avoid confusion that the participants mayencounter if the method used is too comprehensive. d. The method of surplus distribution mustbe flexible, easy to change ormodify by takaful companies if circumstances cause changes in the amount ofsurplus available. e. Distribution of surplus must be consistent and in line with theactuarial basis for the provision of contributions and liabilities. The determination of surplusis essentially an actuarial process because it relies strongly on and sensitiveto the actuarial estimation of liability provisions for the business.
In the distribution ofsurplus, the takaful company should prioritize the interests of takafulparticipants as essentially the surplus is belonging them. When it comes toissues of surplus, the distribution of the surplus must be carried out fairlyand transparent. In implementing surplus administrativeprocess, the following factors need to be considered and taken into account: a. Unrealized profitsThe surplus is distributed on income and actual realized profit. Thismean the future participants will get more benefit than the previous generationof participants as unrealized capital gains are not reflected in previoussurplus distributions. b. Provision for bad investment In takaful industry, provision for bad investmentwhich value has fallen from the value reflected on the purchase will reduce thetakaful surplus.
Therefore, takaful company should rewrite corresponding tothat particular provisions to ensure it benefits the future participants. c. Qardhal HasanThe repayment of the loan, known as Qardhal Hasan should be given priorityover the distribution of surplus to the participants. This is because QardhalHasan is considered as a loan injection into the takaful fund.
d. Determination of a fund-basedsurplus or product portfolioWhile thereis a practical limitation to filter out surpluses to individual participants,efforts must be made to distribute surpluses in a way that identifies theparticular experience of a cohort of participants who share the samecharacteristics. The surplus distributionprocess needs to identify those who qualify for the surplus sharing. Among theeligible participants are as follows:a. takaful participants who havenever made a claim throughout the year.b.
takaful participants who claimless than their risk contribution is paid into the risk pool.c. takaful participants who have made maximum claims are definitely notentitled. (i) Mudarabah Model The mudarabah takaful model works on thefollowing basis: takaful operators (known as shareholders) bear all expensesincurred in operating the business and as a reward, takaful operators areentitled to share underwriting excess and investment profits. This is anadjustment of mudarabah Islamic commercial contracts between takaful operatorand participants (or policyholders) who provide (contribute) the capital. Thebiggest dissent of this model is underwriting excess is non-profit. It isexcess of premium over claims known as surplus.
This business model isdifficult to manage where expenses are fixed but income (surplus) is not.However, this is a very good model from the perspective of participants becausethey do not directly contribute to the operator’s cost. All their contributionsare available to meet claims.
Only when there is any excess of contribution tothe claim, the operator will be compensated for the expenses incurred, and evenif only to the extent that the surplus is sufficient to meet this expense. Contribution into the takaful risk pool isdeemed as donation which under the Islamic contract of tabarru’, towards theexpected increase in claims. The adoption of tabarru’ and the risk-sharingconcept in this risk pool address the Shari’ah’s fundamental concerns aboutconventional insurance. However, the tabarru’ will not be exactly equal withthe 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 forcompanies to commercially viable.
If take away the surplus sharing then thewhole model will collapse. However, the mudarabah takaful modelis an unpopular choice. In Malaysia, only two of takaful operators practicethis mudarabah model. (ii) Wakalah Model Under wakalah model, the surplus is referredto the surplus contributed by the participant into the Risk Fund based ontabarru’ contract.
Upon reaching a financial period, the sum of tabarru’ willnot be equal with the amount the claim. If the tabarru’ amount is less than thesum of claims then the Risk Fund will be deficit, otherwise the tabarru’ amountexceed the claim then the Risk Fund will have a surplus. The wakala model is the default standard fortakaful. Operators charge and carry out takaful operations. For takafuloperators, he makes a profit if wakala fee exceed expenses. The surplus is actually the excess premiumpaid by the participants, so the surplus refund can be explained as aexperience refund. Once this is accepted, then the surplus is belongs of theparticipants.
In Malaysia, several takaful companiesprovide shareholders to share in experience refund. Given that the participantsare responsible for the deficit in the risk pool, it may seem odd thatparticipants should share any excessive contribution to the shareholders. Manysee this as an incentive compensation to the operator to manage the portfoliowell, as evidenced by the surplus. However, whether this incentive is necessarygiven since the operators have already received a fee for underwritingservices.
As practised in Malaysia, wakala models is a model where operatorsonly impose their management and distribution costs through wakala fees, whilethe profits are from the sharing of any underwriting surplus. There is also awakala model where even management expenses and distribution costs are met fromunderwriting surpluses and zero fees are charged. This last extreme wakala modelis similar to the mudarabah model. Even some Shari’ah scholars will alsodescribe mudarabah model as a wakala model with zero fees We can explain this wakala model from theperspective of both participants and operators. From a participant’sperspective, the decision on the use of a wakala model whether operators sharein excessive premiums or not will depend on how much higher is the wakala feehe has to pay. It is not always clear that having a share of the operator inthe the underwriting surplus gives the participants the best value proposition. Fromoperator’s perpective, the wakala fee is determined as the sum of:a.Management expenses;b.
Distribution costs include commissions; andc.Benefits to the operator Given a scenario where thesurplus and deficit are in the participant’s account and where the operator’ssolvency requirements, hence the capital requirements are not excessive. It ispossible to impose a low wakala fee, thereby benefiting the participants. Ifthe operator’s profit depends solely on the underwriting surplus, then such asthe mudarabah model, this wakala model will not be commercially sustainable inthe long run.