A Practical Approach to Reclaiming Solidarity in Islamic Insurance
In this piece I attempt to address an issue that lies at the core of Islamic insurance practice, that is the lack of solidarity that Islamic insurance claims to embody. The discussion features an appendix at the end as a visual aid.
Solidarity vs. Profits in Islamic Insurance Practice
Islamic insurance is referred to in various jurisdictions as cooperative insurance and in others as takaful, literally meaning social solidarity. Theoretically, Islamic insurance has always been advanced as a social solidarity vehicle which is voluntary (tabarru‘) in nature. In Islamic finance practice today, this model is considered wishful thinking. The Islamic insurance sector operates in an environment of the dominant commercial insurance model where risk is taken on by the insurance company for a premium paid by the customer.
Islamic insurance has replicated this conventional model but with the use of fiqh contracts to make it look Islamic, and for a very legitimate reason: people do not want to commit their valuable capital to a non-profit generating undertaking, as is the case with the idealized solidarity-based Islamic insurance. To institute an insurance company, you need capital. The law requires a large capital commitment. This “seed capital” is advanced by private investors who would then own the insurance company. Islamic insurance follows a similar approach as any other approach to voluntarily raise such capital required to start the fund does not seem to have materialized nor does it seem realistic to expect such a thing.
Although it can be imagined that an Islamic insurance cooperative can be initiated through the medium of a small cooperative start-up, insurance is a large-scale business by its nature and depends on the law of large numbers to work properly. This is a universal fact, not some capitalist assumption that Islamic finance could brush aside. This is why a lot of capital is required which is going to come from private hands and which demand profits.
Having said that, I still believe in the ideal that insurance in Islam should be a matter of solidarity. Hence, I argue that a gradual approach is required to reclaiming that solidarity. That approach will entail transitioning from a shareholder owned insurance company to a participant owned insurance company.
A commendable starting point
In the current Islamic insurance practice, a commendable practice is the separation of the funds contributed by shareholders and those contributed by participants to create the risk fund (called the participants’ risk fund, PRF) responsible for meeting the claims of participants. The shareholders own the shareholder’s funds but not the PRF; the PRF is owned by the participants collectively. That means no one participant’ share in the PRF can be pinpointed.
However, if the amount of contributions exceeds claims for a given period, the excess (surplus) is sometimes used to compensate the shareholders for their performance in effective underwriting (where claims were less than contributions) which doesn’t seem fair to the participants, but is nevertheless advanced as a necessary practice of the insurance sector to compensate the demanding shareholders. This is where the purpose of solidarity among compromised and the profit-seeking intent of shareholders conflicts. This is why this separation of funds must also be the starting point for the transition to a solidarity-based Islamic insurance.
The Solution
The gist of the solution I propose is regulation that imposes on Islamic insurance companies to commit a portion of the end-of-period surplus and reserves to buying the shares of the shareholders — a share repurchase plan essentially. The reason this is practical is because Islamic insurance companies must have various reserves at their disposal, it’s the nature of the business. I remember a prominent figure in the Islamic insurance sector flourishing in Malaysia and the UAE telling us in class that insurance was a business of reserves.
I could go into the details of the variety of reserves that insurance companies have, but it would distract from the current proposition.
Shareholder’s funds in Islamic insurance companies are usually invested and not left idle. They are further kept liquid in order to meet any deficiencies in the PRF, which is when claims for the period exceed the premiums collected. The repurchase of these shares will not have a technically significant effect. All that is saying is that the reserves (called technical reserves) are converted from one form to another, namely from shareholders’ funds to reserves of the PRF.
For example, in the current practice, if the PRF goes into deficit, the shareholders must provide an interest-free loan facility from their equity. This amount is earmarked as a solvency provision as a regulatory requirement to make sure the PRF is always solvent. Hence, this earmarked portion, whether it is shareholders’ equity or whether it becomes a reserve in the PRF doesn’t change the state of the PRF since from a technical perspective, the solvency has not really changed. What would have changed is that less of the surplus from underwriting for the year is used to pay profits to shareholders and more is used to buy off shares so that future surpluses are not paid out as profits.
While this solution may seem ideal, practically, it faces some impediments.
Issues with this Proposition
Regulatory resolve
The regulators are required to resolve to resist pressure form the players in the Islamic insurance sector as shareholders are not so easily willing to give up their shares. Alternatively, regulators may facilitate for the public repurchase of shares of the Islamic insurance companies in the markets. A large portion of shares may still remain in the hands of private investors meaning reasonable bargains will have to be made. Regulators are put in a difficult position to balance between interference in the markets and allowing flexibility in the sector.
Time and cost of the transition
The time horizon for an Islamic insurance company to go from being owned by shareholders to being owned by participants may vary greatly based on the circumstances of the company. Some companies have small shareholder equity, a large PRF and massive reserves while others have a more balanced mix of shareholders’ funds and PRF. There are also costs to this transition since in assuming ownership of the insurance undertaking, the participants are also assuming the responsibility for compensating management. This in itself is another issue all together.
The issue of ownership transfer
During the transition, the ownership of the insurance company transitions gradually to the participants. An issue that arises is the apportioning of management expenses. It would seem that the management expenses should be apportioned based on how much shares the participants have purchased relative to the outstanding shares. This is easier said than done since share repurchase may no take place once a year, but instead gradually throughout the year. One can use a weighted method, but this will give rise to conflicts between shareholders and participants, which leads us to the yet another issue.
Another issue that surfaces is representation of the participants on the board. Current Islamic insurance practice gives almost no voice to participants on board decision-making although their contributions are the driving force behind the Islamic insurance company. The return to solidarity will mean representing participants on the board of directors, even during the transition period which may perhaps extend for decades.
Appendix
