Insuring success

Takaful, which is still in its infancy compared to conventional insurance, is expected to remain one of the fastest growing sectors of the insurance industry. The Shari'ah-compliant cover is regarded as likely to benefit from changing socioeconomic characteristics in the Middle East and Asia where there is low insurance penetration, as well as an increasing knowledge of the benefits of insurance.

Other factors likely to help fuel growth include the introduction of compulsory motor and health cover in some countries, combined with the increasing availability of Takaful insurance as an alternative to conventional insurance.

Demographics, combined with increasing wealth in parts of the Middle East and Asia, are expected to help drive growth. It is estimated that one quarter of the world's population - around 1.5 billion people - is Muslim and 60 per cent of Muslims are under the age of 25. Insurance penetration in the Middle East and Asia is low although Islamic countries are believed to produce 23 per cent of the wealth generated by emerging markets.

Projected growth figures for the Takaful market vary hugely but all suggest that it is set to gather pace. But are these phenomenal growth rates realistic?

Although there has been optimism about the prospects for Takaful over the past few years, in reality, Takaful operators have faced challenging times. The economic downturn has created difficulties for all insurance companies around the world, but Takaful operators have faced additional pressures as they tend to be relatively new start-up ventures.

Growth has been lower than expected, largely due to consumers being driven by price during the economic downturn, and buying cheaper cover from conventional insurers. The conventional insurers have been in a better position to offer lower premiums to price sensitive customers. Not only are these insurers usually larger in size, but they tend to have lower expense ratios, plus an existing customer base.

Takaful operators, meanwhile, have suffered from capital adequacy pressures. AM Best's starting point for rating Takaful companies is to use Best's Capital Adequacy Ratio (BCAR) to help assess balance sheet strength. The BCAR tests are run for policyholders' funds, shareholders' funds, and the two combined, and this model has highlighted that Takaful operators have been facing a number of key issues, particularly a lack of financial flexibility for some companies.

Compared to conventional insurance companies, Takaful market participants have much more restricted investment policies, resulting in a high concentration of assets in a sole or in a few investments. As the supply of Sukuk (bond) products in the market is limited, investment in equities tends to be considerably higher than for conventional insurers.

According to International Financial Services London (IFSL), there was an increase in Sukuk issuance from a low of $15 billion in 2008 to $20 billion in 2009. However, the Sukuk market is by no means stable. Troubles with Dubai World as a result of its delayed repayment of a $4 billion Sukuk in December could have shaken the bond market significantly had support not been forthcoming from neighbouring emirate Abu Dhabi.

Furthermore, as operators tend to have a significant equity holding due to the shortage of Sukuk products, Dubai World's delayed repayment is likely to have created volatility in the investment portfolio of a number of Takaful insurers.

Owing to lower than expected demand for Takaful products, combined with investment challenges, some operators have revisited business plans. The ReTakaful market has also had to scale back its predictions to reflect more moderate premium growth and as a result of its relative youth, participants tend to be significantly smaller

than international reinsurers. Many ReTakaful operators are consequently relying on non-Takaful business to achieve critical mass.

Funding challenges are present in all markets and raising money for Takaful ventures has been a worldwide problem. At the end of last year, Salaam Halal Insurance, the UK's first Islamic insurance company which has 10,000 policyholders, closed to new business. It failed to raise sufficient additional capital.

AM Best is also aware that some Takaful and ReTakaful players that were considering setting up at the end of 2008 and at the beginning of 2009 put off their plans as global financial uncertainty created difficulties with obtaining funding.

There are some signs that the Takaful market is seeing increased activity according to data from consultancy firm Ernst & Young. The accountancy firm has noted that Takaful operators dominated the list of initial public offerings in the Middle East during the fourth quarter of 2009, due largely to the flotation of three Saudi Arabia-based insurers.

The biggest was Al Khaleej Insurance (also known as Gulf General Cooperative Insurance Company), raising $21.3 million in the fourth quarter. Meanwhile, Al Alamiya Cooperative Insurance Company and Buruj Cooperative Insurance Company raised $16 million and $13.9 million respectively.

However, Ernst & Young's data demonstrates the financial markets are not completely out of the woods. Total regional initial public offering deals in the Middle East last year were just one-sixth of the value of floats in 2008. The past couple of years have been challenging for the Takaful market, but as the global economic downturn shows further signs of receding, there is hope that the demand for Takaful products will rise.

During this time of continued belt-tightening, the desire to have products designed to be Shari'ah-compliant is outweighed by the need to have cheaper insurance. It will take some time before buyers' mentalities change but there are number of factors which could help Takaful operators win more business.

Takaful operators face intense competition from already established conventional insurers but they could benefit from customer loyalty driven by belief in Takaful principles. Many Muslim nations, which tend to have low insurance penetration, are also experiencing ongoing economic development. This is thought to be a key driver for growth.

Currently, operators do have higher expense ratios than conventional insurers as they lack economies of scale and tend to have a lower use of technology. However, AM Best expects as volumes increase, expense ratios will reduce.

While the prospects remain bright for the Takaful market, there is a need to improve industry risk management practices.

AM Best believes that given the challenges faced by Takaful operators, they must develop and demonstrate their ability to apply an adequate risk-based approach to investment management, given their reduced investment opportunities. Takaful insurers also often have a concentration of risk, offering just a handful of products within a confined geographical space.

As Takaful insurers must build up surpluses in the long term - particularly if they are offering family and life products - capital adequacy and reserving are an especially important part of an operator's risk management approach.

Likewise, operators must demonstrate robust pricing and that adverse selection control systems are in place owing to the fact that operators face restrictions on charging extra risk premiums for policyholders representing a greater risk of loss than the aggregate participant pool.

Additional risk management challenges also include the limited capacity of the ReTakaful market.

While there is potential for the Takaful market to grow, AM Best believes it will only flourish provided appropriate regulatory standards are in place to help promote solid risk management. However, the extent of regulatory intervention will partly depend on the success of Takaful.

As yet, some of the current regulation has to be tested, such as the ring-fencing of assets within the Takaful fund and the use of an interest-free loan (Qard Hassan) from operators in the event of solvency difficulties.

The creation of more consistent standards is already becoming more important. At the end of last year, the Islamic Financial Services Board (IFSB) took an important step in the creation of harmonised regulatory guidelines. By approving the issuance of draft proposals it is attempting to create supervision of Takaful operators "consistent" with that of the conventional insurers.

AM Best believes that in particular, the IFSB's guidelines creating solvency requirements for both the Takaful Fund and the Shareholders' Fund, gives much needed clarity to both regulators and Takaful operators alike. This should result in greater transparency for the Takaful industry, encouraging the establishment and publication of accounts for the separate funds.

Regulation is crucial in helping to create better risk management practices but it is not the sole driver. An insurance rating can additionally act as a focal point for setting a strategic objective, as well as being used for major internal projects such as improving a company's risk management. Although companies seek a rating for a variety of reasons, it can also act as a tool providing independent oversight and support corporate governance processes.

Provided Takaful operators have investors with long term views, the Takaful market should evolve and exercise better risk management practices as new diverse products come on stream.

To avoid competing for market share against more experienced conventional insurers with longer underwriting track records, Takaful operators could look at offering different product lines.

As the Takaful market is still young, the range of products will take some time to develop. However, family Takaful - ranging from saving and retirement products to critical illness cover - could represent an opportunity for growth, as well as diversification.

There generally is a lack of family protection available, and by offering a variety of different types of cover to customers, policyholders could become accustomed to buying Shari'ah-compliant products, rather than being driven back to conventional insurance through lack of choice.

However, if critical mass is not established in lines such as family insurance, Takaful products could be unprofitable. Operators could also look into cross selling products, and diversifying their risks by considering entering new geographical territories.

The Takaful market is very fragmented, with many small market participants and few large dominant players. This could change through increased regulatory requirements, which may in turn lead to better expense ratios in the long-run.

Ernst & Young estimates the size of the global Takaful market could be as high as $7.7 billion by the end of 2012. The challenges for Takaful operators are diverse, ranging from competing against conventional insurance companies, to educating prospective clients about the advantages of Shari'ah-compliant insurance. Yet despite these hurdles, the prospects for the Takaful market still look bright.

Yvette Essen is Head of Market Analysis for AM Best Europe