Takaful Funds in Islamic Finance
A takaful fund is basically a pool of money that participants create to help each other. But such funds can’t survive if a country’s regulations don’t allow for a cooperative legal form of business organization or for companies that lack share capital (capital stock).
For practical reasons, takaful operators (which are usually limited liability companies and may be Islamic banks) exist to manage these pools of funds. And shareholders exist to support a fund’s startup and ongoing administrative expenses.
Each takaful company must keep its participants’ contributions separate from its shareholder funds; the two sources of money can’t be mixed. Therefore, each takaful operator manages two separate funds:
The takaful fund: This fund is the participants’ (policyholders’) money.
The shareholders fund: Also called the operating fund, this account holds the seed money (the paid-up capital) provided by the company’s shareholders. The shareholder fund pays startup administrative expenses, and remaining capital is invested. Any profits from those investments go back into this fund. In addition, takaful participants pay ongoing management fees that are placed in the shareholders fund to support continuing administrative expenses.
Shareholders are rewarded for their investment with explicit fees that are paid out of this fund periodically. In addition, when a takaful fund earns investment profits, shareholders may receive a share of those profits.
An important point to keep in mind is that any takaful fund (regardless of its particular structure) that experiences a deficit during its operation requires underwriting or capital backing; otherwise, the fund can become insolvent. Takaful shareholders underwrite the funds when deficits exist. They do so by giving the fund a qard hasan (interest-free loan).
Later, when the deficit disappears and a surplus accrues, the shareholders deduct the loan amount from fund surpluses.
Wakala model: The principal-agent relationship
In Islam, wakala is a contract in which one entity works as an agent for another. In the case of a wakala-based takaful product, the takaful operator works as an agent on behalf of the takaful participants, who are called the principals. (The operator, or agent, is the wakil.)
The takaful operator manages the fund and receives a pre-agreed percentage of the participants’ fund or fixed fee; this management fee is called a wakala fee. In addition, the takaful operator may charge a performance-based fee, which is its incentive to manage the fund as well as possible.
The takaful operator determines what fee(s) to charge after consulting with the sharia board. Any fees it collects are placed in the shareholders fund and are used to reward the shareholders as well.
Note that any surplus that the takaful fund or the sharia-compliant investments generate goes back to the participant contributions.
Mudaraba model: Partnership
Mudaraba is an Islamic contract based on a financial partnership in which one party (an investor) gives money to another (a fund manager) for the purpose of investing it in a business or economic activity.
The investor puts up all the capital, and the fund manager provides expertise and knowledge to help the activity be successful. Both parties share the profits based on an agreed-upon ratio, but only the investor can lose the initial capital if the activity isn’t successful.
When a takaful product is based on this contract, the shareholders of the takaful company share the profit of the fund with the policyholders. The policyholders are the investing partner (silent partner), called the rab al mal.
The takaful company (the takaful operator and shareholders) is the working partner or fund manager, called the mudarib. The takaful company isn’t liable for any loss (unless the loss stems from the company’s own negligence or misconduct).
Instead, the participants’ fund bears the loss. (The participants stand to lose money; the company stands to lose the value of its time and efforts.) The takaful company receives a percentage of the fund’s surplus (if one exists) and a percentage of any profit from investments made by the fund.
The figure illustrates the mudaraba model as it applies to takaful. Note that the key difference between the mudaraba and wakala model is that a portion of the surpluses from both the takaful fund and the sharia-compliant investments goes into the shareholders fund in a mudaraba-based takaful. The wakala contract rewards shareholders with only a management fee and possibly an incentive fee.
Combination model: Principal-agent relationship and partnership
This structure is the most widely used in the takaful industry and alleviates most criticisms leveled against the pure mudaraba model. Here’s how the combination model works:
Using the wakala contract, the takaful company acts as the agent for the fund management and receives a fee for underwriting the fund.
Using the mudaraba contract, the takaful company acts as the fund manager for managing investments and shares the profit for the investment of the takaful fund.
Note that the company doesn’t receive any portion of a surplus in the participants fund in the combination takaful structure.