While the concept of shari’a-compliant insurance has existed for several decades, it has gained momentum significantly in the past 15 years. Takaful companies have emerged in most Middle East and North Africa (MENA) markets, all seeking to take advantage of this niche and potentially profitable segment. With the exception of Saudi Arabia (where all insurers operate under the unified co-operative insurance model, which is distinctly different from the traditional takaful model), most of the remaining Middle Eastern takaful operators have struggled to establish competitive positions in their respective markets. A.M. Best considers this to be somewhat disappointing, given the natural opportunities of providing shari’a-compliant insurance in countries where Muslims are in the majority.
Takaful Companies Struggle to Establish a Foothold
Despite some market consolidation, the business profiles of the majority of takaful companies remain limited. A.M. Best considers the Middle East insurance markets to be concentrated. Generally, a few large players dominate their respective markets, with the other market participants competing for the remaining premium. For example, the United Arab Emirates (UAE) insurance market has over 60 insurers with the five biggest companies accounting for more than one third of gross premium written. These large insurers tend to be well established with effective brand recognition and have been able to create strong franchises. The smaller, less established participants are left to compete between themselves for the remaining premium as they seek to establish competitive positions in their markets.
Takaful operators generally fall into the latter group, where emphasis is placed on growth over profitability. This often leads to intense levels of competition, with takaful companies competing directly with conventional insurers. Given their relatively new status and position in these markets, takaful operators often lack sufficient size to achieve economies of scale. Their weaker cost efficiencies and start-up nature translates into high cost bases and higher expense ratios which dampen operating performance.
Given the proportion of Muslims in the MENA region, A.M. Best considers the take-up of shari’a-compliant insurance to be disappointing, especially in contrast with the Malaysian experience, which exhibits higher takaful penetration – despite the country having a lower proportion of Muslims.
A.M. Best notes the fact that takaful companies are shari’a compliant is not a specific draw for Muslim consumers. This extends further into the shari’a-compliant insurance eco-system, with shari’a boards of takaful companies being reluctant to obligate their companies to seek retakaful capacity for their reinsurance programs. This has been one of the drivers for retakaful operators failing to establish strong business profile (see A.M. Best’s Special Report: “The Struggle for Retakaful as Competition Bites Sector”, published February 12, 2018).
This contrasts with the Islamic banking sector, where scholars have consistently encouraged Muslim consumers to avoid riba (interest) and bank with shari’a-compliant institutions. As a result, there is greater shari’a sensitivity when it comes to banking than there is to insurance.
Consequently, the footprint of Islamic banking in the MENA region is higher than that of takaful (see Exhibit 1).
Takaful companies generally compete on pricing and servicing, and not through offering a separate unique value proposition (UVP). One of the biggest areas of contention is the return of surpluses to policyholders. Apart from a few companies, takaful operators have generally not made any distributions to policyholders, mostly due to the fact that they have been unable to build up sufficient surpluses. Nevertheless, this has impaired what should have been one of the takaful market’s key UVPs.
Additionally, for many years, MENA takaful companies have hoped the family/life takaful market will gain traction and have developed products designed to meet this expected demand. This follows the Malaysian and Indonesian experience, where family takaful is well established and remains profitable for operators. The difference in business mix between MENA and Malaysian companies can be seen in Exhibit 2.
Merger and Acquisition Gathers Pace
The past few years have seen an uptick in merger and acquisition (M&A) activity in the MENA region, and a large part of this has been in the takaful space. In 2017, Bahrain Kuwait Insurance Company (a conventional insurer) took a controlling share in Takaful International in Bahrain. The reverse was seen with Solidary Group acquiring
a conventional insurer (Al Ahlia in Bahrain). Al Ahlia was subsequently converted to a takaful company and merged with Solidarity’s existing Bahraini operations. This follows Solidarity’s approach in Jordan where its subsidiary First Insurance acquired, merged and converted the conventional insurer Yarmook Insurance.
More recently in the UAE, Takaful Emerat agreed to buy Al Hilal Takaful, potentially creating one of the largest takaful operators in the country and providing Takaful Emarat with access to the general takaful market to complement its family and health takaful offerings. In A.M. Best’s opinion, the lack of scale and size for takaful companies should encourage more acquisitions to allow operators greater market presence. However thus far, only the Al Hilal acquisition has demonstrated this rationale.
Beyond M&A activity, Egypt has seen a number of new takaful companies entering the market including Egyptian Takaful, Orient Takaful, Misr Takaful, and GIG Egyptian Takaful. The trend of new Egyptian takaful companies follows the first publication of takaful specific regulations in the country in 2015. Beyond Egypt the number of new operators entering the market has been limited. In 2017, Orient Insurance (of the UAE) started operating its takaful subsidiary, Orient UNB Takaful. In 2018, Doha Insurance (based in Qatar) announced its intention to incorporate its takaful branch operations. The trend of conventional companies operating or acquiring takaful branches or subsidiaries is not new, and idriven by the attractiveness of an additional distribution platform, rather than for the purpose of achieving scale or gaining market share.
Financial Performance Lags Conventional Players
In general, MENA takaful companies have underperformed compared to their conventional counterparts. Return on Equity (ROE) metrics over the five-year period between 2012 and 2016 show takaful operators struggled to match returns achieved by their conventional peers (see Exhibit 3).
The underlying reason for poorer ROE metrics is the underwriting profitability, which takaful operations have found challenging. As seen in Exhibit 4, combined ratios for the takaful market remained above 100% between 2012 and 2016, whilst conventional insurers demonstrated profitable sub-100% combined ratios over the same period. Combined ratios for takaful companies are calculated by substituting wakala fees for actual management expenses.
A key driver of the higher combined ratios for takaful operators (compared to conventional insurers) is the expense ratio. As mentioned, takaful companies in the region tend to be small, rarely occupying strong market shares and thereby often lacking the economies of scale necessary to cover fixed costs and lower expense ratios. Consequently, on average over the five-year period, expense ratios for takaful operators are more than 10 points higher than conventional insurers.
Additionally, whilst takaful companies tend to compete directly with their more established conventional peers, they generally lack the same brand recognition and distribution capabilities. In order to achieve premium revenue, risk selection and underwriting discipline is often sacrificed for top-line growth. As a result, takaful loss ratios tend to trend higher on average.
However, A.M. Best notes that a number of operators have generated favourable combined ratios, which are comparable to conventional insurers. These operators have either targeted profitable niches, established unique and exclusive distribution channels, or set themselves apart by providing surplus distributions. In other cases, operators that have achieved strong brands and maintained underwriting discipline have also shown good underwriting performance.
The importance of underwriting and pricing discipline can be demonstrated by the results of UAE insurance market in 2017. Following changes to insurance regulations, which mandated actuarial pricing on motor and medical lines, as well setting minimum tariffs for third-party motor insurance, the whole market saw a marked improvement in performance. Takaful companies also saw their performance improve, as stronger pricing helped increase profitability. This can be seen in Exhibit 5, which highlights takaful ROE metrics coming in line with conventional insurers in 2017. (For further information, see A.M. Best Special Report “Regulatory Reforms Lead to Bumper Profits for National Insurers in the United Arab Emirates”, published February 22, 2018).
A key component of A.M. Best’s takaful rating methodology is to determine whether companies demonstrate a good balance of earnings between policyholders’ and shareholders’ funds. Those companies that do so are considered stable and can potentially achieve higher credit ratings. Poor underwriting performance for many Middle Eastern takaful companies reduces the ability to generate profits in their policyholders’ funds.
This is further exacerbated by the high level of wakala fees charged by most Middle Eastern companies. In theory, these fees are designed to cover the expenses incurred by shareholders in management of the policyholders’ fund, and to provide a reasonable margin for profit to cover the operator’s cost of capital. However, in practice the margin applied on expenses is significant.
Over the five-year period between 2012 and 2016, A.M. Best notes that the spread of wakala fee against shareholder expenses (including net incurred commissions) has consistently remained excessive, peaking at 46% in 2015 (see Exhibit 6). The margin reduced significantly in 2016, due to changes in the UAE market, after the regulator imposed a cap on the level of wakala fees that can be charged. Additionally, accounting changes in the UAE meant that all acquisition expenses have to be incurred in the shareholder account, reducing the differentials earned. As a result, wakala margins in the UAE reduced to a more reasonable 4% in 2016, the lowest in the region.
Balance Sheets Remain Unbalanced
Policyholder security depends on having sufficient available capital and liquidity to pay claims – either from independent capitalisation of the policyholders’ fund or from the interest-free loan from shareholders. A.M. Best adopts a two-stage approach to the analysis of the risk-adjusted capitalisation of takaful companies. It is measured for the company as a whole, taking into account the balance sheets and operating activities of both funds, and again for the policyholders’ fund on a standalone basis. In order to be considered for a secure rating, a takaful company must either have an adequate level of capitalisation on both a consolidated basis and within its policyholders’ fund, or be adequately capitalised overall as well as existing in a sufficiently strong regulatory environment. In order to meet this criterion, the regulator must ensure policyholder protection by guaranteeing the permanence of the Qard’ Hassan (the interest-free loan provided by shareholders to cover any deficit in the policyholders’ fund).
Continued annual deficits in policyholders’ funds, reflective of poor underwriting and excessive wakala fees mentioned above, are increasing the level of accumulated deficit and therefore weakening the financial strength of the policyholders’ funds.
Uneven distribution of profit between policyholders and shareholders could be attributed to inadequate incentive structures and governance. Wakala fees are charged as a percentage of gross contributions, incentivising shareholders and operators of companies to concentrate on top-line growth to maximise fee income, rather than profitability which can improve policyholder surplus generation. Unlike other mutual companies, takaful companies do not have policyholder representation on their boards of directors. Instead, these are made of shareholders and independent professionals. Therefore, there is less pressure on management to act in the interest of participants.
Takaful practitioners in the Middle East often point towards the Qard’ Hassan as a counterbalance to the profit transfer achieved with the wakala fee. Theoretically speaking, the provision of a benevolent loan from the shareholders to the policyholders (which should be repaid from future underwriting profits) should increase management’s drive towards improving underwriting profitability and reducing the wakala fee burden. However, in A.M. Best’s opinion, the Qard’ Hassan in the Middle East is treated merely as an accounting transaction, with no actual transfer or ring-fencing of assets. This leads to the ‘Perpetual Qard’ Syndrome’ wherein the deficits and Qard’ Hassan continue to grow without any intention of management to either write-off the loans or transfer assets across to the policyholders.
Some supervisors have intervened to reduce the reliance on Qard’ Hassan. In Bahrain, the regulator requires operators to transfer assets to the policyholders’ fund as part of the Qard’ Hassan provision. Additionally, new takaful-specific regulations in the UAE require a write-off of the Qard’ Hassan every three years. A.M. Best believes these new regulations will help reduce the effects of ‘Perpetual Qard’ Syndrome’ and can be considered marginally credit positive.
Concluding Thoughts
Taking into account the huge global Muslim population, A.M. Best believes that there are significant opportunities for takaful operators to provide sound financial protection that is in line with consumers’ religious sensibilities. However, these opportunities continue to remain disappointingly unrealised, with takaful companies struggling to establish strong business profiles.
Due to a lack of sufficient differentiation, takaful providers remain subject to fierce price competition with larger, more established insurers that already benefit from greater brand awareness and established distribution networks. Furthermore, additional support from shari’a scholars in promoting Islamic financial products is essential for the growth of the takaful sector.
When an improved level of profitability is achieved, it is important that companies achieve a balance of earnings between policyholders and shareholders. Shareholders require dividends to justify their capital investment, but policyholders also have the right to a share of the surplus accruing from the good management of the takaful fund. Retention of surpluses in policyholders’ funds will improve mutuality in line with the takaful model, as well as the level of policyholder protection. This alignment of policyholder and shareholder interests will also help operators differentiate themselves from conventional insurers.
Developments in regulation are also key for policyholder protection. Takaful companies will do well to lobby for more robust, comprehensive and consistent rules in order to improve confidence in the industry and create the right environment for growth. This is particularly important in countries where the regulatory code does not yet deal specifically with takaful.
Those operators with strong business profiles and track records of good operating performance are able to attain higher credit ratings from A.M. Best. Conversely, those who struggle in establishing their franchises, and suffer from poor performance find it harder to attain strong credit ratings. Additionally, a number of takaful companies have had difficulties in meeting minimum solvency rules, which has also led to lower credit ratings.
In conclusion, A.M. Best believes that once the industry tackles these challenges, it will be better placed to serve the needs of the enormous potential market for shari’a-compliant insurance, to the benefit of all stakeholders.
