Best Explains Takaful Rating Methodology

February 15, 2008

A.M. Best Co. announced that it is issuing “Takaful (Shari’a Compliant) Insurance Companies”, a rating methodology which outlines the application of Best’s core financial strength rating methodology to takaful insurance companies.

Best explained that takaful insurance, which complies with Islamic beliefs, is on the rise, particularly in the Middle East and Malaysia. “While takaful insurers share many similarities with conventional mutual operating structures,” Best explained, the rating agency said it “believes that there are distinctive characteristics of takaful insurers that must be considered in the rating evaluation.”

Best described the concept of takaful insurance as “essentially a cooperative risk-sharing program established for the well-being of the community.” The primary purpose is not to generate profits, but to “uphold the Islamic principle of Al-Takaful – ‘bear ye one another’s burden.’ As a result, takaful insurance is based on the concept of mutual cooperation, solidarity and brotherhood. Takaful participants contribute (donate) to help protect one another against the impact of unpredicted risk and catastrophe, whereas in the conventional insurance model, policyholders pay premiums to protect themselves, or their interests, from some form of risk.”

Takaful insurers have certain unique characteristics that recognize the key principles of Al-Takaful and fundamental Islamic beliefs. These include the establishment of two separate funds: A takaful (or policyholders’) fund and an operator’s (or shareholders’) fund.

“The takaful fund operates under pure cooperative principles, in a very similar way to conventional mutual insurance entities,” Best continued. “Underwriting deficits and surpluses are accrued over time within this fund, to which the operator has no direct recourse. As a result, the takaful fund effectively is ‘ring-fenced’ and protected from default of the operator’s fund. Management expenses and seed capital are borne by the operator’s fund, where the main income takes the form of either a predefined management fee (to cover costs) or a share of investment returns and underwriting results (or a combination of both).”

In addition principles of “solidarity” and “equal surplus distribution” govern the fund’s management. “Given the fact that the takaful fund is seen as a pool of risks managed under solidarity principles, it is not meant to accumulate surpluses at levels excessively higher than those strictly needed to protect the fund from volatile results and to support further growth,” Best explained. “Likewise, any fees or profit shares received by the operator should be just sufficient to cover management and capital costs while keeping the company running as an ongoing concern. The surplus distribution structure is expected to be managed carefully and in a balanced way, so that neither policyholders nor operator make excessive profits at the expense of the other party.”

The establishment of a “Shari’a board” is an essential component in a takaful company’s corporate governance in addition to the conventional board of directors. “The Shari’a board is made up of recognized Islamic scholars, who ensure the company’s operational model, profit distribution policies, product design and investment guidelines comply with Islamic principles.”

Best explained that its methodology “outlines how these unique characteristics – and other dynamics in the takaful market – are incorporated into A.M. Best’s financial strength rating assessment process. The discussion includes: a review of the key principles of takaful; how these principles are incorporated into a takaful company’s business model; and, how A.M. Best rating methodologies are applied in the assessment of these organizations.”

To view the takaful rating methodology in full go to: A.M. Best

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