Why the Takaful Fund Has No Capital of Its Own?

Suppose you know a shopkeeper in your area. He runs a small electrical goods store and pays 40,000 a year into a Takaful plan to cover the stock. The brochure explains that participants protect one another. His contribution goes into a shared pool, and any surplus left at year-end belongs to the participants.

The contract is valid.

Then the monsoon arrives early, half the market floods, and the pool pays every claim and runs dry. Someone has to fund the rest of the year's claims. In almost every Takaful operator in the world, that someone is the shareholders. They lend the pool the shortfall, interest-free, and take it back out of future surplus. The loan is called qard. He asked for a mutual and received a pool whose solvency, in the only year that matters, depends on a company's promise.

The participants' risk fund has no capital of its own. Most of what goes wrong in Takaful follows from that sentence.

Why the fund is empty: the economics

In 1985 the legal scholar Henry Hansmann published a paper in the Journal of Law, Economics, and Organization on why insurance companies are organised as mutuals or as stock companies. Mayers and Smith had asked a related question in the Journal of Business in 1981. Their shared observation was that a stock insurer separates two groups, owners who put up capital and policyholders who buy protection, and the two have opposite interests over pricing, reserving and how much risk the company takes. A mutual removes the conflict by making the policyholders the owners.

It removes something else too. A mutual cannot sell shares, so it cannot raise risk capital the way a stock insurer can. Historically, mutuals solved this in two ways. They retained surplus until they had built a reserve, and until that reserve was large enough they gave themselves the right to assess members for more money in a bad year. Early American mutuals wrote assessable policies for exactly this reason.

Takaful took an unusual path. It adopted mutual risk-bearing, since participants donate into a pool and share its fortunes, but it adopted the stock-company organisational form, since a shareholder-owned operator runs the pool. The pool is a mutual with no members' capital and no assessment right, sitting inside a company that cannot be paid to back it. Shariaah does not permit a fee for bearing risk, which the jurists call a fee for guarantee (ḍamān bi'l-ajr). Commercial capital may be paid for managing a pool.

The qard is the patch over that gap. Seen this way, the qard is what a stock company does when it has to carry mutual risk without being allowed to charge for it.

What the patch costs

Three things follow, and the sector shows all three.

Sometimes the loan is quietly written off. A qard that nobody expects to be repaid is a guarantee under another name. The operator has become the risk-bearer, and the mutual has become an insurance company that took a longer road to the same place.

Sometimes the loan is repaid out of surplus that later participants generate. The shopkeeper who joins in a dry year pays for the flood her neighbours suffered before she arrived. Nobody signed up for that.

Most often the risk is priced anyway, out of sight. The agency fee the operator charges for running the pool, is set high. The operator's share of surplus is set high. Shareholders know they carry an unpaid put option on the fund, and they charge for it through the only channels the contract leaves open. Participants pay for a guarantee that Shariah says cannot be sold, and they receive no governance rights for it, because the operator rather than the pool decides pricing, reserving and retakaful.

The diagnosis is shared among most people who have looked closely at the model. What remains open is where a Takāful pool could get risk capital that Shariah permits it to hold.

Maybe the shipowners already solved it

Two industries have run mutual risk pools without shareholder capital for a very long time, and both did it by solving the assessment problem and the scale problem together.

Protection and indemnity clubs insure most of the world's merchant fleet against third-party liabilities. Each club is a mutual owned by the shipowners it insures. Members pay an advance call at the start of the year and can be asked for a supplementary call if claims run high. Since 1899 the clubs have also pooled their large claims through what is now the International Group of P&I Clubs: each club retains claims up to a fixed amount, the group pool shares claims above it, and the group buys reinsurance above the pool. No club needs a shareholder behind it. Its members, its retained reserves and the other clubs are its capital.

Cooperative banks in Germany and Austria did the same thing for banking. The Raiffeisen and Volksbank networks belong to institutional protection schemes, arrangements under which the members guarantee one another's solvency and monitor one another to keep the guarantee honest. The European Union's Capital Requirements Regulation recognises these schemes in Article 113(7), and the Raiffeisen and Desjardins movements capitalised new member banks with federation loans repaid out of the new bank's retained earnings.

European insurance regulation has also settled the question of whether a member call counts as capital. Solvency II, the EU's insurance solvency regime, counts a mutual's right to call supplementary contributions from its members as ancillary own funds under Article 89, ranked as Tier 2 capital under Article 96. And cooperative law in Italy and France requires a fixed share of each year's surplus to go into an indivisible reserve that cannot be distributed to members even on dissolution.

None of these was designed with Takaful in mind. Together they describe a pool that capitalises itself from the only two sources Shariah allows to bear insurance risk without payment: the participants, through mutuality, and dedicated capital, through waqf. Then why not build the Takāful fund the way the shipowners built theirs?

What the fund would look like

Take the shopkeeper's operator again. Instead of a pool backed by a shareholder qard, the participants' risk fund is built with the following design choices.

Give the fund legal personality. Legal personality settles who owns retained surplus. The participant dedicates the contribution at the moment of payment. The ownerless-surplus debate that has run through the Takaful literature for a decade ends by construction.

Lock part of every surplus into an indivisible reserve. A prescribed slice of each year's surplus, say a quarter, becomes permanent risk capital that no board and no dissolution can distribute. What remains follows a published ladder tied to the fund's capital ratio: nothing is distributed below a floor, part inside a corridor, all of it above a ceiling with a contribution rebate on top. Dutch pension funds run indexation on a funding-ratio policy of this kind. Surplus stops being a discretion and becomes a rule.

Give participants a capped call. The participant's contribution is already a binding conditional commitment to donate (iltizām bi'l-tabarruʿ). A commitment to donate a further capped amount, say up to 20 per cent of the annual contribution if the pool needs it, is the same commitment extended one step. For commercial and group business the call is unremarkable. For retail business the cap keeps it bearable and the next step covers anyone who cannot pay.

Federate the pools. A national or regional Takaful Solidarity Pool, is funded by a levy on each member fund's retained surplus and by reciprocal commitments among the funds, on the model of the P&I group pool and the cooperative protection schemes. When a member fund runs a deficit, the solidarity pool advances qard or a donation. This is the step that replaces the shareholder qard outright.

Launch new funds from the federation. A fund on its first day has no retained surplus. The solidarity pool lends launch capital as qard, repaid out of the indivisible reserve as it builds, as the Raiffeisen federations did for new banks. Where philanthropic seed capital is wanted, Indonesia's Cash Waqf Linked Sukuk offers a live template: investors get their principal back and the return is dedicated.

Reduce the operator to a pure agent. With no qard to provide, shareholder capital covers operational risk only, and the fee should fall to the price of a service with no guarantee attached. Two safeguards replace the discipline the qard used to impose. Part of the fee is deferred and clawed back if reserves develop badly, the way bank remuneration rules apply malus to bonuses. And a participants' committee takes a seat in the operator's governance with sight of pricing, reserving and retakāful, on the model of the With-Profits Committee that UK life insurers must maintain.

Either way, the shopkeeper would finally be offered the mutual benefit the brochure described. Would he take it?

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

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