How Does a Takaful (Shariah-Compliant) Captive Differ From Other Captives?

Managers of several captive domiciles are positioning themselves to play an important role in Shariah-compliant (Takaful) captives. But what is Shariah-compliant insurance, how does it operate, and what role does it play in captive operations?

Shariah-Compliant Insurance

A Shariah-compliant insurer is a company that undertakes insurance-like activities, conducted in a Shariah-compliant manner in its entire operations. This includes the contract between the Takaful company and the participating scheme members (policyholders), as well as the investment undertakings.

While Islamic scholars recognize the role of risk sharing in economic growth, conventional insurance poses a number of problems with regard to Shariah principles, including the potential for uncertainty (gharar); excessive profit, usury, or interest (riba); and gambling (maysir), which are all prohibited (haram).

How Does a Takaful Operate?

Takaful developed as an alternative to conventional insurance. The key distinction between Shariah-compliant insurance and conventional insurance lies in the relationship between the Takaful company and the policyholders (or participating scheme members). Takaful is an arrangement in which the participants in a risk-sharing scheme agree to indemnify each other against certain losses or damage. To this end, they pool their contributions (premiums) into a common fund to pay compensation (claims). There is no transfer of risk; rather, all participating scheme members give up individual rights to gain collective benefits.

Commercial Takaful arrangements are managed on a for-profit basis by a thirdparty Takaful company (sometimes called the Takaful operator). However, the shareholders of a Takaful operator (unlike those of a conventional commercial insurance company), do not take all profits from the arrangement. Rather, the Takaful operator serves as manager to, and representative of, the participating scheme members.

The role of the Takaful operator is effectively that of manager and entrepreneur. It collects the contributions from the participating scheme members and, for a fee, manages and invests them on behalf of the participating scheme members, who are entitled to share in the surplus generated. In effect, the Takaful operator maintains two separate and distinct accounts or funds:

Takaful/Tabarru fund (or risk sharing fund), which includes the contributions of the participating scheme members.
Takaful operator fund (or shareholders’ fund), which generally includes shareholder reserves and capital.

The segregation of these funds is central to Shariah-compliant insurance.

The Takaful fund is available for regulatory capital adequacy requirements and is invested by the Takaful operator in a Shariahcompliant manner. Any deficit of the Takaful fund is covered by an interest-free loan (Qard Al Hasan, Quard loan, or facility) from the Takaful operator’s fund, the terms of which generally depend on regulatory capital adequacy requirements.

Because the loan may be repaid out of future surpluses of the Takaful fund, the only risk assumed by the Takaful operator with regards to its shareholders’ fund typically is non-repayment in the event of a failure to generate surpluses in the Takaful fund. The Takaful operator’s fee for managing the company is based on a percentage of contributions and/or a share of the underwriting surplus or investment profits, depending on the operating model.

Three Takaful Operating Models

There are essentially three Takaful operating models used by most of the commercial operators worldwide. Regardless of the model, there cannot be a guaranteed level of surplus in order to remain Shariah-compliant. The difference between these three Takaful models lies in the status of the operator and how the operator’s remuneration is calculated and paid:

Wakala: The Takaful operator is regarded as a manager and earns a predetermined/fixed fee for its services, which may include management and performance-incentive components. Any surplus from the Takaful fund will be distributed to the participating members.
Mudaraba: The Takaful operator is manager of the participating scheme members, and is entitled to earn a fee from the share of underwriting and investment profits derived from the Takaful fund.
Hybrid: The hybrid model incorporates a Wakala arrangement with respect to underwriting activities and a Mudaraba arrangement with respect to investment activities. There is a growing consensus that the leading practice for commercial Takaful operations will be the hybrid model.

Ultimately, the formation of a Shariah-compliant captive is fundamentally similar to a conventional captive, except that the operations of a Shariah-compliant captive shall be managed in a Shariah-compliant manner in its entire operations, including the contract between the parent and the captive company as well as the investment undertakings.

Operational Requirements

Like conventional captive companies, the purpose of a Shariah-compliant captive is to manage corporate risk and curb losses. The Sharia-compliant captive establishes those goals in accordance with Shariah principles. The Shariah-compliant captive model involves the parent company transferring its risks to the Shariah-compliant captive while following these key operational requirements:

The parent company appoints the Shariah-compliant captive to be its agent to manage the parent company’s risks and risk financing strategy in accordance with Shariah principles as approved by the company’s appointed Shariah advisor/scholar. The management strategy includes underwriting, contributions, risk assessments, and compensation management, among others.
The investment activities undertaken by the Shariah-compliant captive must be in accordance with Shariah principles as approved by the company’s appointed Shariah advisor/scholar.
All other operational requirements applicable to insurance and insurance-related companies in the chosen jurisdiction of registration must be followed at all times as long as the requirements do not contradict Shariah principles.

The operational model must be based on contracts preferred by the Shariah-compliant captive and approved by its Shariah advisor/ scholar. In setting out the policies and procedures, the Shariah-compliant captive must ensure that the principles are appropriately operationalized. The operational model of activities defines the relationship and fiduciary duties between the contracting parties.

When establishing a Shariah-compliant captive, the memorandum and articles of association must stipulate that its operations are to be carried out in a Shariah-compliant manner and should include provisions for the establishment of an internal Shariah advisory board that will advise on the operations of its business to ensure compliance with Shariah principles.

The Takaful captive must appoint a captive manager that has adequate knowledge and expertise in managing insurance business in a Shariah-compliant manner. A Takaful captive must ensure that its business operations are in accordance with Shariah principles, including ensuring:

The types of risks to be assumed into the Takaful captive are Shariah-compliant themselves.
The appointed Shariah advisor/scholar must establish the guiding criteria on the type of risks to be assumed into the Takaful captive.
Any investment activity is channeled to Shariah-approved investments and the distribution of dividends, profits, etc. must be consistent with Shariah principles.

In principle, Shariah-compliant insurance programs all have a requirement to use a Shariah-compliant fronting insurer (or Takaful operator), a Shariah-compliant reinsurer (or Retakaful operator), Shariah-compliant investments, and most importantly, a Shariah board. However, depending on the jurisdiction where the risk is situated, the availability of sufficient Retakaful capacity and the in-depth knowledge of the Shariah board, conventional insurance may be used in the absence of takaful/retakaful.

Marsh Insights: Captives, December 2013