Takaful - Collective Pricing and Risk-Weighted Pricing of Tabarru’

The amount of tabarru’ collected from participants is important because it provides the financial resources for the Participants’ Risk Fund (PRF) to pay valid covered claims.

However, participants do not necessarily bring the same level of risk into the pool.

Some participants may have a relatively low expected claims risk, while others may have a higher expected claims risk.

This creates an important pricing question:

Should every participant pay the same tabarru’, or should the tabarru’ differ according to the risk each participant brings into the pool?

Two approaches can be considered:

Collective pricing

and

Risk-weighted pricing

1. What Is Collective Pricing?

Collective pricing means participants within a particular pool are charged a common or average tabarru’ rate, even though their individual risk levels may differ.

In simple terms:

Different levels of risk → Same or average tabarru’ rate

The tabarru’ is based on the average risk of the group rather than being individually adjusted for each participant’s specific risk.

2. Simple Collective Pricing Example

Suppose four participants have different expected claim costs:

Ahmad

Expected claim cost = RM200

Ali

Expected claim cost = RM400

Sarah

Expected claim cost = RM1,200

Fatimah

Expected claim cost = RM200

Total expected claims:

RM200 + RM400 + RM1,200 + RM200 = RM2,000

Average expected claim cost:

RM2,000 ÷ 4 = RM500

Under a simplified collective pricing approach, each participant could therefore contribute:

RM500 tabarru’

Total tabarru’ collected:

RM500 × 4 = RM2,000

3. What Happens Under Collective Pricing?

Although everyone pays RM500, their expected risks are different.

Ahmad

Expected risk cost = RM200

Tabarru’ = RM500

Ahmad contributes more than his individual expected risk cost.

Sarah

Expected risk cost = RM1,200

Tabarru’ = RM500

Sarah contributes substantially less than her individual expected risk cost.

Therefore, collective pricing can involve:

Cross-subsidisation

where lower-risk participants effectively contribute relatively more toward the overall cost of higher-risk participants.

4. Is Cross-Subsidisation Always a Problem?

Not necessarily.

Risk pooling itself involves participants collectively sharing losses.

However, a problem can arise when the common tabarru’ rate creates incentives for participants to decide whether to enter or remain in the pool based on their individual risk.

This becomes particularly important when participation is:

Voluntary

because participants can choose whether the common price is attractive to them.

5. Collective Pricing Works Better With Compulsory Membership

Suppose all four participants are required to remain in the pool.

Then:

Total tabarru’ collected = RM2,000

Total expected claims = RM2,000

The low-risk and high-risk participants remain together.

Therefore, the averaging mechanism can continue to function.

This is why collective pricing can work more effectively when membership in the relevant pool is compulsory.

The basic idea is:

Compulsory Membership → Low and High Risks Remain Together → Average Pricing More Sustainable

6. Problem With Voluntary Membership - Anti-Selection

When participation is voluntary, collective pricing can create:

Anti-selection

also commonly called:

Adverse selection

Anti-selection occurs when the pricing arrangement makes participation relatively more attractive to higher-risk participants and less attractive to lower-risk participants.

In simple terms:

The people most likely to claim may find the common price attractive, while people less likely to claim may find it too expensive.

7. Simple Anti-Selection Example

Suppose everyone must pay:

RM500 tabarru’

Ahmad has a relatively low expected risk:

RM200

Ahmad may think:

“My expected risk is much lower than RM500. This arrangement seems expensive for me.”

He may decide not to participate.

Sarah has a much higher expected risk:

RM1,200

but she only needs to contribute:

RM500.

The common rate may therefore appear relatively attractive to Sarah.

As a result:

Lower-risk participants → More likely to leave or not join

while:

Higher-risk participants → More likely to join or remain

This changes the risk composition of the pool.

8. Why Is Anti-Selection Dangerous?

Suppose the original tabarru’ rate was calculated assuming the pool contained:

many low-risk participants

and

some high-risk participants.

Now many low-risk participants leave.

The remaining pool contains a greater proportion of:

Higher-risk participants

Therefore:

Average expected claims increase.

But if the tabarru’ remains at the old average level, the PRF may no longer collect enough money to support the new risk profile.

The process becomes:

Common Average Tabarru’

↓

Low-Risk Participants Find It Relatively Expensive

↓

Some Low-Risk Participants Leave

↓

Higher-Risk Participants Become a Larger Part of Pool

↓

Average Expected Claims Increase

↓

Tabarru’ May Become Inadequate

↓

Greater Risk of PRF Deficit

9. What Is Risk-Weighted Pricing?

An alternative is:

Risk-Weighted Pricing

Under risk-weighted pricing:

The tabarru’ payable by each participant is linked to the amount of risk that participant brings into the risk pool.

Therefore:

Different Risk → Different Tabarru’

A participant presenting higher expected claims risk would generally contribute a higher tabarru’ than a participant presenting lower expected claims risk, subject to the applicable pricing framework.

10. Simple Risk-Weighted Pricing Example

Suppose actuarial analysis estimates:

Ahmad

Expected claim cost = RM200

Ali

Expected claim cost = RM400

Sarah

Expected claim cost = RM1,200

Fatimah

Expected claim cost = RM200

Under a very simplified risk-weighted approach:

Ahmad’s tabarru’ = RM200

Ali’s tabarru’ = RM400

Sarah’s tabarru’ = RM1,200

Fatimah’s tabarru’ = RM200

Total tabarru’:

RM200 + RM400 + RM1,200 + RM200

= RM2,000

Total expected claims:

RM2,000

The total amount collected reflects the total expected risk, while the amount contributed by each participant more closely reflects that participant’s individual expected risk.

11. Why Does a Higher-Risk Participant Pay More Tabarru’?

The purpose is not to punish the participant.

The objective is to ensure that the contribution reflects the expected financial cost of the risk being introduced into the PRF.

Suppose:

Participant A has expected claim cost = RM300

Participant B has expected claim cost = RM1,000

If both contribute only:

RM300

then Participant B’s expected risk is significantly underfunded.

If many participants similar to B enter the pool, the PRF may collect insufficient tabarru’ relative to its expected claims.

Therefore:

Higher Expected Risk → Higher Required Risk Contribution

12. Risk Factors Can Affect Tabarru’

The actuary may consider relevant risk characteristics when determining the expected claims cost.

Depending on the type of Takaful product, relevant factors can include matters such as:

age

health characteristics

occupation

type and value of property

claims history

sum covered

and other relevant factors permitted within the applicable regulatory and underwriting framework.

The purpose is to estimate:

How much expected claims risk does this participant bring into the pool?

13. Higher-Risk Participant Illustration

Suppose a particular participant is assessed as presenting a higher expected claims risk than other participants.

For example:

Expected claim frequency for lower-risk participant = 2%

Expected claim frequency for higher-risk participant = 6%

Suppose the expected amount payable if a claim occurs is:

RM20,000

For the lower-risk participant:

2% × RM20,000 = RM400

For the higher-risk participant:

6% × RM20,000 = RM1,200

Therefore:

Lower expected risk cost = RM400

Higher expected risk cost = RM1,200

This helps explain why the actuarially determined tabarru’ may differ between participants.

14. Claim Frequency and Claim Severity

Two important elements in determining expected claims are:

Claim Frequency

How often claims are expected to occur.

and

Claim Severity

How large the claims are expected to be when they occur.

A simplified formula is:

Expected Claim Cost = Expected Claim Frequency × Expected Claim Amount

For example:

Expected claim frequency = 5%

Expected claim amount = RM20,000

Therefore:

5% × RM20,000 = RM1,000

Simplified expected claim cost:

RM1,000

This provides an actuarial basis for determining an appropriate risk contribution.

15. Why Historical Claims Data Is Important

Actuaries cannot know exactly what will happen in the future.

Instead, they analyse relevant information such as:

historical claim frequency

historical claim severity

participant characteristics

sum covered

claims trends

and other relevant risk information.

The process can be understood as:

Historical Claims Information

↓

Identify Relevant Risk Characteristics

↓

Estimate Claim Frequency

↓

Estimate Claim Severity

↓

Estimate Expected Claim Cost

↓

Determine Appropriate Risk-Weighted Tabarru’

16. What Happens When More High-Risk Participants Enter the Pool?

Suppose a pool initially contains mostly lower-risk participants.

Expected total claims:

RM1 million

The required tabarru’ would be determined with reference to that risk profile and other relevant actuarial considerations.

Now suppose the same number of participants remains, but the pool contains many more higher-risk participants.

Expected claims might increase to:

RM2 million

Under risk-weighted pricing, the higher-risk participants would generally contribute higher tabarru’ amounts.

Therefore:

More High-Risk Participants

↓

Higher Total Expected Claims

↓

Higher Risk-Weighted Tabarru’ Requirements

↓

Higher Total Tabarru’ Collected

This helps the PRF’s funding respond to changes in the risk composition of the pool.

17. Why Is This Important for the PRF?

The PRF needs sufficient financial resources to meet valid covered claims.

Suppose the pool becomes significantly riskier, but tabarru’ remains unchanged.

Then:

Risk increases

but:

Tabarru’ does not increase

This creates a mismatch.

For example:

Total tabarru’ = RM10m

Expected claims increase to = RM14m

Potential expected funding gap:

RM4m

Therefore, risk-weighted pricing helps align:

Risk Accepted ↔ Tabarru’ Collected

18. Does Risk-Weighted Pricing Guarantee That Tabarru’ Will Be Enough?

No.

Risk-weighted pricing is based on expected claims, but actual claims remain uncertain.

Suppose:

Expected total claims = RM10m

Appropriate tabarru’ collected = RM10m, in a simplified illustration.

But unexpectedly severe claims result in:

Actual claims = RM15m

Then:

RM15m − RM10m = RM5m

Claims are RM5m higher than expected.

Therefore:

Risk-weighted pricing improves the relationship between expected risk and contributions, but it cannot eliminate uncertainty.

19. Why Can Actual Claims Differ From Expected Claims?

Claims can differ because of:

random fluctuations

unexpectedly large claims

changes in claim frequency

changes in claim severity

catastrophic events

inflation

and other unforeseen developments.

Therefore, appropriate pricing is only one part of sound Takaful risk management.

The PRF may also rely on:

appropriate margins

technical provisions

retained surplus

financial buffers

Retakaful

diversification

and sound:

risk management.

20. Expected Claims vs Actual Claims

This distinction is extremely important.

Expected Claims

An actuarial estimate made before the future claims are known.

For example:

Expected claims = RM10m

Actual Claims

The claims that actually emerge.

For example:

Actual claims = RM12m

Therefore:

Expected claims are an estimate; actual claims are the eventual experience.

This is why actuarial pricing can improve the probability of adequate funding but cannot guarantee the exact outcome.

21. Does Risk-Weighted Pricing Remove Risk Sharing?

No.

This is one of the most important concepts.

Suppose:

Ahmad contributes = RM300

Ali contributes = RM600

Sarah contributes = RM1,000

Fatimah contributes = RM500

They contribute different amounts because their risks differ.

But their tabarru’ still goes into:

The common Participants’ Risk Fund

If Ali subsequently suffers a valid covered loss of:

RM20,000

he does not simply receive his:

RM600

back.

His valid covered claim is paid from the collective PRF, according to the applicable terms.

Therefore:

Different contribution amounts do not eliminate mutual risk sharing.

22. Pricing and Risk Pooling Are Different Concepts

This distinction is very useful.

Pricing asks:

How much should each participant contribute to the risk pool?

Risk pooling asks:

How are the covered financial losses of participants shared?

Under risk-weighted Takaful:

Participants can pay different tabarru’ amounts

while:

their covered risks remain collectively pooled through the PRF.

Therefore:

Risk-Weighted Pricing ≠ Individual Self-Insurance

The participant is still part of a mutual risk-sharing arrangement.

23. Collective Pricing and Risk-Weighted Pricing Compared

Collective Pricing

The contribution is based on a:

common or average rate.

Therefore:

Low risk → Same/average tabarru’

Medium risk → Same/average tabarru’

High risk → Same/average tabarru’

This can create cross-subsidisation and may encourage anti-selection when participation is voluntary.

Risk-Weighted Pricing

The contribution is linked more closely to individual expected risk.

Therefore:

Lower risk → Lower tabarru’

Medium risk → Moderate tabarru’

Higher risk → Higher tabarru’

This helps the total contributions collected adjust when the overall risk profile of the pool changes.

24. Connection With PRF Deficit

Suppose many higher-risk participants enter the pool but continue paying a tabarru’ amount designed for a lower-risk population.

Then:

Higher-Risk Pool

↓

Expected Claims Increase

↓

Tabarru’ Remains Too Low

↓

Insufficient PRF Funding

↓

Claims May Exceed Available Resources

↓

Greater Risk of PRF Deficit

Risk-weighted pricing helps reduce this mismatch by adjusting contributions to reflect expected risk.

25. Connection With Solvency

Appropriate pricing also contributes to the financial sustainability of the Takaful arrangement.

The process is:

Proper Risk Assessment

↓

Appropriate Tabarru’

↓

Adequate PRF Funding

↓

Greater Ability to Meet Claims

↓

Stronger Financial Sustainability

However, pricing alone cannot guarantee solvency.

Financial strength also depends on:

actual claims experience

technical provisions

investment performance

Retakaful

liquidity

capital support

and other risk-management measures.

26. Connection With Surplus and Deficit

Suppose:

Total relevant PRF income = RM10m

Relevant claims, costs and provisions = RM8m

Simplified result:

RM10m − RM8m = RM2m surplus

However, if claims and relevant obligations instead become:

RM12m

then:

RM10m − RM12m = −RM2m

The PRF has a:

RM2m deficit

Therefore, appropriate risk-weighted pricing improves the starting financial position by aligning tabarru’ with expected risk, but the eventual result still depends on actual experience.

27. Why the Actuary Is Important

The actuary helps determine appropriate tabarru’ by assessing:

Who is entering the pool?

What level of risk do they bring?

How frequently are claims expected?

How severe could claims be?

What is the expected total claims cost?

and:

How much tabarru’ should be collected to support those risks?

Therefore, actuarial pricing helps prevent the PRF from accepting increasing amounts of risk without receiving an appropriate corresponding amount of tabarru’.

Easy Way to Remember

COLLECTIVE = AVERAGE

Participants with different risks pay a common or averaged tabarru’ rate.

Possible problem:

Low-risk participants pay relatively more

while:

High-risk participants pay relatively less

If participation is voluntary, this can contribute to:

Anti-selection

RISK-WEIGHTED = RISK-BASED

The tabarru’ reflects the expected risk each participant brings into the pool.

Therefore:

Lower Expected Risk → Lower Tabarru’

Higher Expected Risk → Higher Tabarru’

But all participants still share their risks through the:

Common PRF

Simple Formula

A simplified actuarial starting point is:

Expected Claim Cost = Expected Claim Frequency × Expected Claim Amount

For example:

5% × RM20,000 = RM1,000

Therefore, the expected claim cost is:

RM1,000

The actuary then considers the relevant risk characteristics and other actuarial factors when determining the appropriate tabarru’.

Anti-Selection Formula

Remember:

Common Average Tabarru’

• ●

Voluntary Participation

↓

Lower-Risk Participants May Find the Price Less Attractive

↓

Higher-Risk Participants May Find the Price More Attractive

↓

Pool Becomes Higher Risk

↓

Expected Claims Increase

↓

Greater Risk of Insufficient Tabarru’

Risk-Weighted Pricing Formula

Participant’s Risk ↑ → Expected Claims Cost ↑ → Required Tabarru’ ↑

At the pool level:

Higher Overall Risk → Higher Expected Claims → Higher Required Total Tabarru’

This helps keep the PRF’s contributions more closely aligned with the risks it is accepting.

One-Sentence Summary

Collective pricing applies a common or averaged tabarru’ rate to participants with different risk levels and can encourage anti-selection when participation is voluntary, whereas risk-weighted pricing links each participant’s tabarru’ more closely to the expected risk they bring into the pool, helping total contributions reflect total expected claims while preserving mutual risk sharing through the common Participants’ Risk Fund.

Takaful - Elements Determining Gross Contribution

The gross contribution is the total amount that a participant pays into a Takaful plan.

The image explains that the actuary first determines the appropriate tabarru’ amount/rate based on the risk being covered. After that, other components are added to determine the total or gross contribution payable by the participant.

The basic structure is:

Gross Contribution = Tabarru’ Rate + Wakalah Fee + Surplus Loading (Optional)

Each component serves a different purpose and should not be confused with the others.

1. Role of the Actuary in Determining Tabarru’

One important actuarial responsibility is determining how much tabarru’ should be charged for the risk.

Remember:

Tabarru’ = contribution allocated to the common risk fund for mutual protection.

The amount should not simply be guessed.

The actuary estimates it based on the expected cost of claims.

A simplified approach is:

Expected Claim Cost = Expected Claim Frequency × Expected Amount Payable Per Claim

The image refers to the expected sum payable should a claim arise, which is essentially the expected claim amount/severity used in the calculation.

2. What Is Expected Claim Frequency?

Claim frequency means how often claims are expected to occur.

For example, suppose historical data shows that among:

1,000 similar participants

approximately:

50 claims

occur each year.

Then:

Expected Claim Frequency = 50 ÷ 1,000 = 5%

This means the actuary expects approximately 5 claims for every 100 similar risks, on average.

It does not mean the actuary knows exactly which participants will claim.

3. What Is the Expected Sum Payable?

This refers to the amount the fund expects to pay when a covered claim occurs.

Suppose historical claims data indicates that the average covered claim is:

RM20,000

The actuary can combine this with the expected claim frequency.

If:

Expected claim frequency = 5%

Expected claim payment = RM20,000

Then:

5% × RM20,000 = RM1,000

So the simplified expected claims cost per similar risk is:

RM1,000

This provides a starting point for determining the appropriate risk-related tabarru’ amount.

4. Why Does the Actuary Use Historical Claims Data?

The actuary needs evidence to estimate future claims.

Historical claims data from similar risks can provide information about:

how frequently claims occur

and

how large those claims tend to be.

For example, when pricing Motor Takaful, the actuary may analyse past claims for participants with similar relevant risk characteristics.

The basic process is:

Historical Claims Data

↓

Estimate Claim Frequency

• ●

Estimate Claim Severity/Amount

↓

Estimate Expected Claims Cost

↓

Determine appropriate risk-based Tabarru’ rate

5. Tabarru’ Should Reflect Risk

The image states that the tabarru’ rate is determined actuarially based on:

Risk factors of participants

and

Sum covered

This means participants with different risk exposures may require different tabarru’ amounts.

This is called risk-based pricing.

6. Example - Different Risks, Different Tabarru’

Suppose Ahmad and Ali both purchase Motor Takaful.

Ahmad

Lower expected risk based on the relevant rating factors.

Expected claims cost = RM700

Ali

Higher expected risk based on the relevant rating factors.

Expected claims cost = RM1,200

It would not necessarily be financially appropriate to charge both exactly the same risk contribution.

The actuarial calculation may therefore produce different tabarru’ rates.

The principle is:

Higher Expected Risk → Higher Required Risk Contribution

7. Why Does the Sum Covered Matter?

The sum covered represents the amount of protection provided, subject to the certificate terms.

Generally, a greater amount of exposure can result in a greater potential financial obligation for the PRF.

For example, consider two similar covered properties:

Property A sum covered = RM500,000

Property B sum covered = RM2 million

All else equal, the potential financial exposure associated with Property B can be greater.

Therefore, the sum covered is an important factor in actuarial pricing.

8. First Component - Tabarru’ Rate

The first component of gross contribution is therefore:

Tabarru’ Rate

This is the risk-related contribution determined actuarially.

The money allocated as tabarru’ goes into the:

Participants’ Risk Fund (PRF)

The PRF is then used collectively to pay valid covered claims.

Therefore:

Participant pays Tabarru’

↓

Tabarru’ enters PRF

↓

Risks are pooled

↓

PRF pays covered claims of participants

9. Why Must the Tabarru’ Rate Be Adequate?

This connects directly with your previous topic on pricing adequacy.

Suppose the actuarially appropriate tabarru’ is:

RM800 per participant

But only:

RM500

is actually allocated.

Shortfall:

RM800 − RM500 = RM300 per participant

For 10,000 participants:

RM300 × 10,000 = RM3 million

The PRF could be underfunded by approximately RM3m relative to that simplified requirement.

Therefore:

Inadequate Tabarru’ → Insufficient PRF Funding → Greater Deficit Risk

10. Second Component - Wakalah Fee

The second component is the:

Wakalah Fee

Remember:

Wakalah = agency arrangement

The Takaful operator acts as:

Wakil = Agent

while participants are:

Principals

The operator manages the Takaful operation on behalf of the participants and receives a fee for performing that role.

Therefore:

Wakalah fee = remuneration paid to the Takaful operator for managing the Takaful business.

11. What Does the Wakalah Fee Cover?

According to the image, the Wakalah fee can include amounts relating to:

Administrative expenses

For example:

employee salaries

office expenses

IT systems

claims administration

customer service

compliance

and other operational costs.

12. Return/Cost Associated With Shareholders’ Capital

The image also identifies a portion relating to the cost of shareholders’ capital, described there as their profit margin.

Shareholders provide financial capital to establish and support the Takaful operator.

They generally expect a reasonable return for providing that capital and taking the associated business risk.

Therefore, the operator cannot necessarily operate indefinitely by charging fees that merely cover its immediate administrative expenses.

It also needs a sustainable business model.

This connects with what you studied earlier:

Treating participants fairly does not necessarily mean charging the lowest possible Wakalah fee.

The fee should be reasonable while allowing the operator to operate sustainably.

13. Sales Intermediary Commission

Part of the gross contribution may also support commissions paid to:

agents

brokers

or other:

sales intermediaries

For example, an agent introduces Ahmad to a Family Takaful product and completes the sale.

The intermediary may receive a commission according to the applicable remuneration arrangement.

This forms part of the distribution/acquisition cost of selling Takaful.

14. Why Must Wakalah Fees Be Carefully Managed?

Suppose:

Gross contribution = RM1,000

Wakalah fee = RM200

Then, in a very simplified example:

RM800 remains for tabarru’/risk funding.

If the PRF actuarially requires RM800:

Adequate

But suppose Wakalah fee becomes:

RM400

Then:

RM1,000 − RM400 = RM600

If the PRF still actuarially requires:

RM800

there is a:

RM200 funding gap

Therefore, the operator’s fee structure should not undermine the actuarial adequacy of the PRF.

15. Important - Wakalah Fee and Tabarru’ Have Different Purposes

Do not mix them up.

Tabarru’

Purpose:

Fund the participants’ risk pool and covered claims.

Goes to:

PRF

Wakalah Fee

Purpose:

Compensate the operator for managing the Takaful operation and cover relevant operator costs/remuneration.

Goes to:

Takaful operator/shareholder fund according to the structure

Therefore:

Tabarru’ funds the risk; Wakalah fee funds/remunerates the management of the arrangement.

16. Third Component - Surplus Loading

The third component shown is:

Surplus Loading

But importantly, the image states that this is:

OPTIONAL

This means it is not necessarily included in every Takaful contribution.

A surplus loading is an additional amount built into the contribution where there is an intention to build up surplus that may support future surplus refunds/distributions, subject to the applicable structure and rules.

17. Why Include a Surplus Loading?

Suppose a Takaful arrangement intends to return/distribute surplus to eligible participants when experience is favourable.

If the pricing is designed only to cover the central expected cost with no additional allowance, there may be less room for a surplus to emerge.

Therefore, the pricing structure may include an additional:

Surplus Loading

This can help create additional financial strength and increase the possibility of surplus emerging if actual experience is favourable.

However:

Surplus loading does NOT guarantee that participants will receive a surplus distribution.

18. Example of Surplus Loading

Suppose the contribution is constructed as:

Tabarru’ = RM800

Wakalah fee = RM200

Optional surplus loading = RM100

Therefore:

Gross Contribution = RM800 + RM200 + RM100

Gross Contribution = RM1,100

The participant therefore pays:

RM1,100

But this does not mean the participant is guaranteed to receive the RM100 back later.

19. Why Isn’t the Surplus Loading Guaranteed to Come Back?

Because actual claims experience could be worse than expected.

Suppose the additional RM100 is included, but during the year the PRF experiences unexpectedly high claims.

That additional financial amount may contribute to absorbing those adverse claims.

Therefore:

Surplus Loading Included

does not mean:

Guaranteed Surplus Distribution

Actual surplus still depends on the fund’s financial experience and applicable provisions, expenses, liabilities and regulatory requirements.

20. Connection With the Actuary’s Role in Surplus Distribution

This connects directly with the previous topic.

Suppose a surplus eventually emerges.

The actuary still needs to assess:

Is the surplus genuine?

What technical provisions are required?

How volatile are claims?

Does the PRF need a financial buffer?

Would distribution jeopardise future claim payments?

Only after these considerations can an appropriate surplus distribution be considered.

Therefore:

Surplus loading may help create the potential for surplus, but it does not create an automatic right to receive a surplus refund.

21. Surplus Loading vs Financial Buffer

These concepts are related but different.

Surplus Loading

An additional pricing component included when determining the gross contribution.

It is established:

Before actual claims experience is known.

Financial Buffer

Financial resources maintained to absorb adverse future experience.

It may be strengthened by:

retaining actual surplus in the PRF.

So:

Surplus Loading → Pricing stage

while:

Financial Buffer → Financial strength/risk absorption

22. Surplus Loading vs Actual Surplus

Also do not confuse:

Surplus Loading

An amount deliberately incorporated into the pricing structure.

with:

Actual Underwriting Surplus

A positive result that actually emerges from the PRF’s experience after relevant claims, costs, provisions and obligations are taken into account.

Therefore:

Loading is planned in pricing; surplus is an actual financial outcome.

23. Surplus Loading vs Pricing Margin

This is another important distinction because you previously studied margin.

Pricing Margin

An allowance for uncertainty/adverse deviation in expected claims.

Purpose:

Protect against claims being worse than the central estimate.

Surplus Loading

An optional additional pricing component associated with an intention to provide for a potential surplus refund/distribution.

Purpose:

Build additional amount into pricing where surplus refund is intended.

They should therefore not automatically be treated as the same thing.

24. Bringing the Three Components Together

Suppose Ahmad purchases a Takaful plan.

The actuarial and pricing process determines:

Tabarru’ Rate = RM700

This reflects Ahmad’s risk and contributes to the PRF.

Wakalah Fee = RM200

This compensates/supports the operator in managing the Takaful operation.

Optional Surplus Loading = RM100

This is included because the structure intends to provide for potential surplus refund/distribution.

Therefore:

Gross Contribution = RM700 + RM200 + RM100

Gross Contribution = RM1,000

Ahmad pays:

RM1,000 total gross contribution

25. What Happens to Ahmad’s RM1,000?

Conceptually:

RM700

→ Tabarru’ / PRF

→ Used collectively for covered risks and claims.

RM200

→ Wakalah fee

→ Supports/remunerates management of the Takaful operation.

RM100

→ Optional surplus loading

→ Additional pricing component associated with the intended surplus arrangement.

The precise accounting/fund treatment depends on the particular Takaful model and regulatory framework.

26. The Actuary’s Overall Pricing Process

The process can be understood as:

Analyse Historical Claims

↓

Estimate:

Claim Frequency

↓

Estimate:

Expected Claim Amount / Severity

↓

Calculate:

Expected Claims Cost

↓

Adjust for:

Participant Risk Factors + Sum Covered

↓

Determine:

Tabarru’ Rate

↓

Add:

Wakalah Fee

↓

Add, if applicable:

Optional Surplus Loading

↓

Determine:

Gross Takaful Contribution

Easy Way to Remember

Use:

RISK + MANAGEMENT + OPTIONAL SURPLUS

RISK = Tabarru’

Money required to fund the risk pool and covered claims.

MANAGEMENT = Wakalah Fee

Money used to compensate/support the operator for managing the Takaful business.

OPTIONAL SURPLUS = Surplus Loading

Additional pricing component where the arrangement intends to provide for potential surplus refund/distribution.

Therefore:

Gross Contribution = Risk + Management + Optional Surplus

Simple Formula

From the exhibit:

Gross Contribution = Tabarru’ Rate + Wakalah Fee + Optional Surplus Loading

And the simplified actuarial starting point for the risk cost is:

Expected Claims Cost = Expected Claim Frequency × Expected Claim Amount

For example:

5% × RM20,000 = RM1,000

The actuary then considers the relevant risk characteristics, sum covered and other pricing considerations in determining the appropriate tabarru’ rate.

One-Sentence Summary

The gross contribution paid for a Takaful plan can be viewed as consisting of an actuarially determined tabarru’ rate reflecting the participant’s risk and sum covered, a Wakalah fee for managing and distributing the Takaful business, and, where applicable, an optional surplus loading intended to provide for potential surplus refunds; the actuary uses historical claims frequency and claim amounts together with relevant risk factors to determine an appropriate risk-based tabarru’ rate.

Takaful - Role of an Actuary in Calculating Appropriate Technical Provisions

Another important role of an actuary in Takaful is to calculate the appropriate technical provisions that must be recognised in the financial accounts at the end of the financial year.

Technical provisions are important because a Takaful entity may have financial obligations relating to:

future coverage that has already been provided for under existing certificates, and

claims from events that have already happened but have not yet been fully reported or settled.

Therefore, the financial accounts cannot simply look at how much cash was received and how much cash was paid during the year.

The key principle is:

Recognise the financial obligations that belong to the reporting period, even when the actual cash payment may happen later.

This is necessary to avoid overstating the financial strength, profitability or surplus of the Takaful operation.

1. What Is a Technical Provision?

A technical provision is an amount recognised in the accounts for obligations arising from Takaful coverage and claims.

In simple terms:

Technical provision = an accounting amount recognised today for Takaful obligations that still need to be fulfilled.

It does not necessarily mean that the operator takes that exact amount of cash and puts it into a separate bank account.

Instead, it represents a liability recognised in the financial accounts.

2. Why Are Technical Provisions Necessary?

Imagine the PRF has:

RM20 million income

and only:

RM10 million claims paid in cash during the year.

It might initially appear that:

RM20m − RM10m = RM10m

is available as surplus.

But suppose another:

RM6 million of valid claim obligations

relate to events that have already occurred but have not yet been paid.

If we ignore the RM6m simply because the cash has not yet left the fund, we could seriously overstate the surplus.

Therefore, appropriate liabilities must be recognised.

Conceptually:

Income = RM20m

Claims paid = RM10m

Additional claim obligations = RM6m

So the financial position cannot be assessed merely as:

RM20m − RM10m = RM10m

The outstanding obligations must also be considered.

3. The Actuary’s Role

The actuary estimates the appropriate amount of technical provisions that should be maintained in the accounts.

The actuary normally considers factors such as:

historical claims experience

claim frequency

claim severity

claims development patterns

outstanding claims

future obligations

uncertainty

and other relevant actuarial assumptions.

The actuary would normally provide an actuarial assessment or sign-off concerning the adequacy of the provisions.

In simple terms, the actuary asks:

“Have we recognised enough liability for the Takaful obligations that still exist?”

4. Why Does the Actuary Need to “Sign Off” on Adequacy?

Suppose management wants to recognise:

Technical provisions = RM5 million

But actuarial analysis indicates that:

RM9 million

would be required to appropriately reflect the relevant obligations.

If only RM5m were recognised, liabilities could be understated by:

RM4 million

This could make the financial position look stronger than it really is.

For example:

Reported surplus might appear to be:

RM7m

when a more appropriate provision could reduce it to:

RM3m.

Therefore, actuarial assessment provides an important safeguard against underestimating liabilities and overstating surplus.

5. Two Important Types of Liability

Under the IFRS 17 terminology in your material, two important liabilities are:

1. Liability for Remaining Coverage - LRC

and

2. Liability for Incurred Claims - LIC

The easiest way to distinguish them is:

LRC = the covered event has NOT happened yet.

LIC = the covered event HAS already happened.

That distinction is extremely important.

6. Liability for Remaining Coverage - LRC

Liability for Remaining Coverage (LRC) relates to the entity’s obligations under the unexpired portion of existing coverage.

In simple terms:

The participant is already covered, but part of the coverage period is still in the future.

The covered event has not yet occurred, but the Takaful fund still has an obligation to provide coverage during the remaining period.

7. Simple LRC Example

Suppose Ahmad obtains a one-year General Takaful certificate:

Coverage period: 1 January to 31 December

At:

30 June

only six months have passed.

Coverage has already been provided for:

January → June

But coverage is still required for:

July → December

The second half of the coverage period is still unexpired.

Therefore, there is still an obligation relating to the:

Remaining coverage

This is the basic idea behind LRC.

8. Why Can’t the Entire Contribution Immediately Be Treated as Earned?

Suppose Ahmad pays:

RM1,200

for one year of coverage.

For a simple illustration, assume the coverage is spread evenly over 12 months.

That works out to:

RM1,200 ÷ 12 = RM100 per month

After six months, conceptually:

Coverage already provided = 6 months

Coverage remaining = 6 months

The Takaful arrangement still owes Ahmad another six months of coverage.

Therefore, it would be misleading to treat the entire RM1,200 as if all the coverage obligations had already been completed.

The exact IFRS 17 measurement is more sophisticated than simply dividing the contribution equally by months, but this example helps explain the concept.

9. Easy Way to Understand LRC

Think:

LRC = “We still owe you COVERAGE.”

The participant has an existing certificate.

The future insured event has not happened.

But the Takaful arrangement still has an obligation to provide protection for the unexpired coverage period.

So:

Existing Certificate + Future Coverage Remaining = LRC

10. Liability for Incurred Claims - LIC

The second important liability is:

Liability for Incurred Claims (LIC)

This relates to covered events that have already occurred.

The Takaful fund may still need to:

investigate

assess

process

and

pay

the resulting valid claims.

Therefore:

LIC = the insured event has already happened, but the resulting claim obligations have not necessarily been fully settled.

11. Simple LIC Example

Suppose Sarah has Motor Takaful.

On:

20 December

she is involved in a covered accident.

The financial year ends:

31 December

But the claim is only fully settled:

15 February of the following year.

At 31 December:

Has the insured event happened?

Yes.

Has the claim been completely paid?

No.

Therefore, an obligation already exists at year-end.

The Takaful fund cannot say:

“We haven’t paid Sarah yet, so there is no liability.”

The event occurred before the reporting date.

Therefore, the relevant claim obligation needs to be recognised.

This falls under:

LIC

12. Easy Difference Between LRC and LIC

Remember these two questions:

LRC

Has the insured event happened yet?

No.

There is still future coverage to provide.

LIC

Has the insured event happened?

Yes.

There is now a claim-related obligation to investigate and/or pay.

So:

LRC = Coverage remaining

LIC = Claims already incurred

13. LIC Includes Claims That Have Not Yet Been Reported

This is where actuarial estimation becomes especially important.

Not every claim that has occurred will be reported immediately.

For example:

An accident happens on:

29 December

The financial year ends:

31 December

The participant reports the claim:

5 January

At 31 December, management may not even know about this particular claim.

But economically:

The event has already happened.

Therefore, an appropriate actuarial provision needs to allow for claims that have occurred but have not yet been reported.

This leads to:

IBNR

14. What Is IBNR?

IBNR = Incurred But Not Reported

It means:

The insured event has already occurred, but the claim has not yet been reported to the Takaful operator by the reporting date.

Example:

Accident occurs = 28 December 2026

Financial year-end = 31 December 2026

Claim reported = 5 January 2027

At 31 December:

Event occurred? → Yes

Claim reported? → No

Therefore:

IBNR

15. Why Is IBNR Necessary?

Suppose the operator only counts claims that have already been reported.

Reported outstanding claims:

RM5 million

But based on historical experience, the actuary estimates that another:

RM2 million

of claims have probably already occurred but have not yet been reported.

Without IBNR:

Claim liability recognised = RM5m

With the actuarial estimate:

RM5m + RM2m = RM7m

Therefore, ignoring IBNR would understate the claim liability by:

RM2 million

and potentially overstate the surplus by the same amount, all else equal.

16. What Is IBNER?

The material also refers to:

IBNER = Incurred But Not Enough Reported

This means the claim has already been reported, but the amount currently recorded is not sufficient to represent the eventual expected claim cost.

In simple terms:

The operator knows about the claim, but the claim is expected to cost more than currently estimated.

17. Simple IBNER Example

Suppose Ali has a serious accident.

He reports the claim before year-end.

Initially, the estimated claim amount is:

RM100,000

Therefore, the operator records:

RM100,000

But the actuary reviews claims development and concludes that the eventual cost is more likely to be:

RM150,000

Therefore, an additional:

RM50,000

needs to be allowed for.

That additional development is an example of the concept behind:

IBNER

So:

Claim already reported = Yes

Current estimate sufficient = No

Therefore:

IBNER

18. IBNR vs IBNER

This is very easy to remember:

IBNR

Claim event happened

BUT

Claim not reported yet

Example:

Accident happened on 30 December, reported on 5 January.

IBNER

Claim already reported

BUT

Not enough has been recognised for its eventual cost

Example:

Initially estimated at RM100,000, but expected ultimate cost becomes RM150,000.

19. Why Is an Actuary Needed for IBNR and IBNER?

If a claim has not yet been reported, management cannot simply look at the claims register and find it.

The actuary therefore uses:

historical claims patterns

reporting delays

claims development

frequency

severity

statistical methods

and other relevant information

to estimate these obligations.

For example, historical experience might show that at every year-end, approximately 10% of certain claims are reported after the reporting date.

The actuary can use historical and current information to estimate the expected liability.

Therefore:

Actuarial work helps recognise obligations that may not yet be fully visible in the accounting records.

20. Why Technical Provisions Affect Surplus

This is one of the most important connections.

Suppose before technical provisions:

PRF appears to have:

RM10 million surplus

But the actuary determines that additional claim obligations of:

RM6 million

need to be recognised.

Then, in a simplified illustration:

RM10m − RM6m = RM4m

The more realistic surplus is:

RM4 million

rather than:

RM10 million

Therefore:

Technical provisions prevent the PRF from appearing more profitable or having more distributable surplus than is actually justified.

21. Why This Matters for Surplus Distribution

This connects directly with the previous topic.

Imagine the operator says:

“We have RM10m surplus. Let’s distribute it.”

But the actuary identifies:

IBNR = RM2m

IBNER = RM1m

and other relevant liabilities.

After recognising appropriate technical provisions, the surplus may be much smaller.

If the operator distributed the original RM10m without recognising these obligations, the PRF could later discover that it does not have enough resources to pay valid claims.

Therefore:

Calculate Technical Provisions

↓

Determine More Accurate Financial Position

↓

Determine Genuine Surplus/Deficit

↓

Then Consider Surplus Distribution

22. Accrual Basis of Accounting

Technical provisions are necessary because financial accounts are generally prepared on an accrual basis.

The basic idea of accrual accounting is:

Recognise income and expenses/obligations in the period to which they relate, rather than looking only at when cash is received or paid.

This is extremely important in insurance and Takaful because claims can occur in one year but be paid in another year.

23. Cash Basis vs Accrual Basis Example

Suppose:

Accident occurs = December 2026

Claim amount = RM500,000

Claim paid = February 2027

If we looked only at cash:

2026 claim payment = RM0

2027 claim payment = RM500,000

But this could give a misleading picture because the insured event actually occurred in:

2026

Under accrual-based financial reporting, the relevant liability should be recognised in connection with the period in which the obligation arose, according to the applicable accounting requirements.

Therefore:

No cash payment yet does not mean no liability exists.

24. Technical Provisions Prevent Overstatement of Surplus

Without adequate technical provisions:

Liabilities appear too low

↓

Financial position appears too strong

↓

Surplus/profit appears too high

↓

Too much surplus might be distributed

↓

Future claim-paying ability could be weakened

Therefore:

Adequate Technical Provisions = More Accurate Financial Position

25. Technical Provisions Also Affect Solvency

Remember:

Solvency concerns whether sufficient financial resources are available to meet obligations.

Suppose:

PRF assets = RM100m

Initially recognised liabilities = RM70m

The position may look strong.

But the actuary discovers that appropriate technical provisions should actually make total relevant liabilities:

RM95m

Now the financial position looks very different.

Therefore, accurate technical provisions are necessary when assessing:

Solvency

If liabilities are underestimated, solvency may appear stronger than it actually is.

26. Technical Provisions Can Reveal a PRF Deficit

Technical provisions may also determine whether the PRF actually has a:

surplus

or

deficit.

Suppose before additional actuarial provisions:

PRF financial result = +RM3m

The actuary determines additional appropriate provisions of:

RM5m

Simplified adjusted result:

RM3m − RM5m = −RM2m

The PRF now shows:

RM2 million deficit

Therefore, what initially looked like a surplus can become a deficit after appropriate obligations are recognised.

27. Connection With Qard

This is why technical provisions can affect whether qard support is required.

Suppose the year-end accounts show:

PRF deficit = RM5 million

Under the applicable Takaful framework, the shareholder/operator fund may need to provide:

Qard

to support the PRF.

Remember:

Qard is an interest-free loan, not a donation.

It is generally recoverable from future PRF surpluses according to the applicable rules.

Therefore:

Actuary calculates provisions

↓

Liabilities properly recognised

↓

True PRF financial position determined

↓

If positive → Surplus

If negative → Deficit

↓

If deficit → Qard support may be required under the applicable framework

28. Connection With Financial Buffer

This also connects with the financial buffer you just studied.

These concepts should not be confused.

Technical Provision

Recognises obligations that need to be reflected in the accounts.

Financial Buffer

Provides additional financial strength against adverse or unexpected experience.

For example:

Expected/recognised claim obligations = RM10m

Technical provisions appropriately reflect those obligations.

An additional financial buffer may then help protect against claims experience becoming worse than expected.

So:

Technical provision = recognise the obligation

Financial buffer = help absorb adverse uncertainty beyond expected/recognised experience

Both contribute to financial soundness, but they perform different functions.

29. The Whole Process

The easiest way to understand the actuary’s role is:

Financial Year Ends

↓

Identify Remaining Coverage

↓

Calculate LRC

↓

Identify Claims Already Incurred

↓

Calculate LIC

↓

Include estimates such as:

IBNR + IBNER

↓

Recognise Appropriate Technical Provisions

↓

Determine More Accurate Liabilities

↓

Determine Financial Position

↓

Surplus or Deficit

↓

Assess:

Solvency

↓

If PRF deficit exists:

Qard may be required under applicable framework

Easy Way to Remember

Use:

LRC = LATER EVENT

The insured event has not happened yet.

There is still remaining coverage.

LIC = EVENT ALREADY HAPPENED

The insured event has already occurred.

There is now a claim-related obligation.

IBNR = HAPPENED, NOT REPORTED

Incurred But Not Reported

Event happened, but the operator does not yet have the claim report.

IBNER = REPORTED, BUT NOT ENOUGH

Incurred But Not Enough Reported

The claim is known, but the current recognised estimate is insufficient for the expected ultimate cost.

Simple Example Bringing Everything Together

Suppose the financial year ends on:

31 December 2026

Ahmad

His certificate runs until June 2027.

No insured event has occurred.

There is still future coverage to provide.

→ LRC

Ali

Accident happened on 20 December 2026.

Claim reported on 22 December.

Still unpaid at year-end.

→ LIC

Sarah

Accident happened on 30 December.

She reports it on 5 January 2027.

At year-end the event had occurred, but the claim had not been reported.

→ LIC including IBNR

Fatimah

Accident happened and was reported before year-end.

Initial estimate = RM50,000

Actuarial assessment indicates ultimate cost = RM80,000

Additional expected development = RM30,000

→ LIC including IBNER concept

Most Important Distinction

Remember these four questions:

Has coverage not yet expired?

→ LRC

Has the insured event already occurred?

→ LIC

Has it occurred but not been reported?

→ IBNR

Has it been reported but the current amount is insufficient?

→ IBNER

Simple Formula

Conceptually:

Appropriate Technical Provisions = Obligations for Remaining Coverage + Obligations for Incurred Claims

or:

Technical Provisions → LRC + LIC

with LIC including appropriate estimates for claims such as:

IBNR and IBNER

The exact measurement under IFRS 17 is more detailed than this simplified formula.

One-Sentence Summary

The actuary calculates and assesses the adequacy of technical provisions so that the Takaful accounts properly recognise obligations relating to remaining coverage (LRC) and claims that have already occurred (LIC), including estimates such as IBNR and IBNER; this prevents surplus from being overstated, provides a more accurate assessment of solvency and financial performance, and can help determine whether a PRF deficit exists that may require qard support under the applicable Takaful framework.

Takaful - What Is a Financial Buffer?

A financial buffer is an amount of financial resources kept available to help a Takaful fund absorb unexpected losses, higher-than-expected claims, or other adverse financial events.

In very simple terms:

Financial buffer = extra financial strength kept for a bad day.

It is called a buffer because it creates a cushion between the fund’s normal expected financial needs and a situation in which the fund becomes financially distressed.

1. Why Do We Need a Financial Buffer?

Future claims cannot be predicted perfectly.

Suppose the actuary estimates:

Expected claims next year = RM10 million

But actual claims could be:

RM9m

RM10m

RM12m

or even:

RM15m

The RM10m is an estimate, not a guarantee.

If the PRF only has exactly enough resources for RM10m and actual claims become RM15m, the fund may face financial difficulty.

Therefore, it is prudent to maintain additional financial resources.

That additional protection is what we mean broadly by a:

Financial buffer

2. Simple Example

Suppose the PRF expects:

Claims and other relevant obligations = RM20 million

But it has:

RM25 million of appropriate financial resources

The additional:

RM5 million

provides a cushion against adverse experience.

You can think of:

RM20m → Expected requirements

RM5m → Additional financial protection

So, conceptually:

Financial Resources = Expected Requirements + Financial Buffer

This is simplified because actual regulatory and actuarial calculations are more complex.

3. Where Does the Financial Buffer Come From?

“Financial buffer” is a general concept, not necessarily one specific account called the “Financial Buffer Account.”

Depending on the context and regulatory framework, financial resilience can come from several sources, such as:

retained/accumulated surplus in the PRF, appropriate reserves or provisions, capital, Retakaful protection, and other required financial resources.

In the section you are currently studying, the particularly important buffer is:

Surplus retained in the PRF

Instead of distributing the entire surplus to participants, some may remain in the PRF to help absorb future claims fluctuations.

4. Example - Retained Surplus Becomes a Buffer

Suppose the PRF generates:

RM6 million surplus

The actuary considers future claims uncertainty and recommends:

Distribute = RM2m

Retain in PRF = RM4m

The retained:

RM4 million

strengthens the PRF and acts as a financial buffer against future adverse claims experience.

Suppose next year claims are unexpectedly:

RM3 million higher than expected.

The accumulated resources can help the PRF absorb that adverse experience.

So:

Surplus today → Retained in PRF → Financial buffer → Helps absorb future bad claims

5. What Happens Without the Buffer?

Suppose the entire:

RM6m surplus

was distributed.

The PRF therefore does not retain that RM6m as additional accumulated strength.

Next year:

Expected claims = RM20m

Actual claims = RM24m

Unexpected additional claims:

RM4m

The PRF may now be more vulnerable to a deficit.

Depending on the circumstances and applicable Takaful structure:

Unexpected Claims → PRF Deficit → Potential Qard Support

So retaining an appropriate buffer can reduce the PRF’s dependence on external support.

6. Why Does Claims Volatility Affect the Required Buffer?

Remember:

Claims volatility = claims fluctuate significantly from one period to another.

Suppose PRF A has claims:

RM10m → RM10.5m → RM9.8m → RM10.2m

These claims are relatively stable.

Now PRF B has:

RM5m → RM18m → RM7m → RM25m

PRF B has much greater claims volatility.

Therefore, the actuary may be more cautious about distributing PRF B’s surplus.

Why?

Because:

Greater volatility → Greater uncertainty → Greater possibility of unexpectedly high claims → Greater need for financial protection

So:

Higher Claims Volatility → Greater Need for Financial Buffer

7. Why Is It Called a “Buffer”?

Think about the bumper of a car.

A bumper helps absorb an impact.

A financial buffer performs a similar economic function:

Unexpected financial shock

↓

Buffer absorbs part/all of shock

↓

Core financial position is better protected

For Takaful:

Unexpectedly High Claims

↓

Financial Buffer

↓

PRF better able to absorb claims

↓

Lower risk of severe deficit

That is why the word buffer is used.

8. Financial Buffer Is Not the Same as Surplus

This distinction is important.

Surplus

A surplus is a positive financial result remaining in the PRF after relevant obligations and provisions have been accounted for.

For example:

PRF income RM20m − relevant claims/costs RM16m = RM4m surplus

Financial Buffer

A financial buffer describes financial resources available to absorb adverse future experience.

If the RM4m surplus is retained in the PRF, it can contribute to the PRF’s financial buffer.

Therefore:

Surplus can be a source of financial buffer, but “surplus” and “financial buffer” do not mean exactly the same thing.

9. Financial Buffer Is Also Not Exactly the Same as a Reserve

This is another useful distinction.

A reserve/provision generally represents amounts recognised for particular expected or incurred obligations, depending on the accounting/actuarial context.

For example, suppose the PRF knows that claims have already occurred but some have not yet been paid.

It may need to recognise:

RM5m claims provision

That RM5m is not simply “extra money available to distribute.”

It relates to obligations that need to be met.

A buffer, on the other hand, refers more broadly to additional financial capacity available to absorb unexpected adverse experience.

So conceptually:

Reserve/Provision → Expected or recognised obligations

Buffer → Protection against adverse/unexpected experience

The exact terminology and calculation depend on the regulatory and accounting framework.

10. Financial Buffer Is Also Different From Pricing Margin

You have now encountered three related terms:

Pricing Margin

Used when pricing the product.

Example:

Expected claims = RM700

Margin for uncertainty = RM100

Pricing requirement = RM800

It helps recognise uncertainty before future experience occurs.

Surplus

Arises from the actual financial performance of the PRF.

Example:

PRF underwriting income = RM20m

Relevant claims/costs = RM17m

Surplus = RM3m

Financial Buffer

Financial strength retained/available to help absorb future adverse experience.

Example:

Of the RM3m surplus:

RM2m retained

That RM2m strengthens the PRF’s buffer.

So:

Margin → built into assumptions/pricing for uncertainty

Surplus → positive result after experience

Buffer → financial protection maintained against future adverse experience

11. Connection With the Actuary

Now the previous section should make more sense.

Suppose:

PRF surplus = RM10m

Participants may naturally ask:

“Why don’t we distribute the whole RM10m?”

The actuary may respond:

“Because claims are volatile. If we distribute the entire RM10m, the PRF may not have enough financial strength if next year’s claims are unusually high.”

The actuary might therefore recommend:

RM3m → distribute

RM7m → retain

The RM7m strengthens the PRF’s financial buffer.

12. Connection With the “Next Big Claim”

This explains the statement you just studied about retaining surplus for the next “big claim.”

Suppose:

Year 1 retained surplus = RM2m

Year 2 retained surplus = RM3m

Year 3 retained surplus = RM2m

Accumulated retained surplus:

RM7 million

Then Year 4 has unexpectedly severe claims.

Additional adverse claims experience:

RM6 million

The PRF already has accumulated financial strength from earlier years.

Therefore:

Earlier Surpluses → Accumulated Buffer → Absorb Later Claims Volatility

This is also how risk sharing can extend across different years.

13. Connection With Qard

Suppose a PRF has:

No accumulated financial buffer

and unexpectedly experiences:

RM5m deficit

The shareholder/operator fund may need to provide qard, depending on the applicable Takaful framework.

Now suppose the PRF had accumulated sufficient surplus from previous years.

That accumulated financial strength may help absorb the adverse experience before the PRF needs external support.

Therefore:

Stronger PRF Buffer → Lower Potential Dependence on Qard

This is one reason why distributing every surplus immediately may not be prudent.

14. Connection With Solvency

A financial buffer also supports solvency.

Remember:

Solvency = ability to maintain sufficient financial resources to meet obligations.

If a PRF has very little financial cushion, a single adverse year can put it under severe pressure.

If it has an appropriate financial buffer, it has greater capacity to withstand:

unexpectedly high claims

claims volatility

catastrophes

and other adverse financial developments.

Therefore:

Financial Buffer → Greater Loss-Absorbing Capacity → Stronger Financial Resilience

Easy Example to Remember

Imagine Ahmad expects his monthly expenses to be:

RM4,000

But he keeps:

RM10,000 emergency savings

He does not expect to spend that RM10,000 every month.

It exists because unexpected things can happen:

car repair

home repair

or another unexpected expense.

That RM10,000 is Ahmad’s financial cushion or buffer.

The PRF follows a similar general principle:

Do not maintain resources only for what you expect to happen; maintain appropriate financial strength for the possibility that actual experience is worse than expected.

Easy Way to Remember

Think:

BUFFER = SHOCK ABSORBER

Normal expected claims

↓

Unexpected large claims occur

↓

Financial Buffer absorbs the shock

↓

PRF remains stronger

↓

Lower risk of deficit / qard dependence

Simple Formula

Conceptually:

Expected Financial Requirements + Additional Loss-Absorbing Capacity = Stronger Financial Position

And in the surplus context:

Surplus Generated → Part Distributed + Part Retained

The retained portion can contribute to:

Financial Buffer

Therefore:

Retained Surplus → Financial Buffer → Absorb Claims Volatility → Protect Future Claim-Paying Ability

One-Sentence Summary

A financial buffer is additional financial strength maintained to absorb unexpected losses or higher-than-expected claims; in Takaful, retaining part of the PRF’s surplus instead of distributing it can strengthen this buffer, helping the fund withstand claims volatility, protect future claim payments and reduce the likelihood of a deficit or reliance on qard.

Takaful - Role of an Actuary in Determining Surplus

An important responsibility of the actuary in Takaful is not only to calculate whether the Participants’ Risk Fund (PRF) has generated an underwriting surplus, but also to determine:

whether that surplus is safe to distribute, how much can be distributed, and who is eligible to receive it.

The most important principle is:

The existence of a surplus does not automatically mean that the entire surplus should be distributed.

Some or all of the surplus may need to remain in the PRF as a financial buffer against future claims volatility.

1. First, What Is a Surplus?

Recall the basic concept.

Suppose the PRF receives:

Relevant PRF income = RM20 million

During the year:

Claims = RM12 million

Retakaful costs = RM2 million

Other relevant expenses/provisions = RM3 million

Simplified result:

RM20m − RM12m − RM2m − RM3m = RM3m

Therefore:

Underwriting surplus = RM3 million

There is a positive balance after the relevant obligations and provisions have been taken into account.

But the next question is:

Should the entire RM3 million now be distributed?

Not necessarily.

2. The Actuary Has to Assess the Surplus

The actuary considers whether distributing the surplus would leave the PRF financially strong enough to meet future obligations.

Therefore, the actuary is not simply asking:

“Is there a surplus?”

The more important question is:

“How much of this surplus, if any, can safely be distributed without jeopardising the PRF’s ability to pay future claims?”

This distinction is extremely important.

3. Surplus Does Not Automatically Mean Distribution

Suppose:

PRF surplus = RM10 million

It might seem attractive to distribute:

RM10 million

to eligible participants.

But suppose the actuary knows that claims are highly volatile.

Historical claims might have been:

Year 1 = RM10m

Year 2 = RM12m

Year 3 = RM25m

Year 4 = RM11m

Year 5 = RM30m

The PRF may have a surplus today, but another very large claims year could occur in the future.

Therefore, the actuary may recommend:

Retain part or all of the surplus in the PRF.

4. Why Retain Surplus?

One major reason is to create a margin or buffer against fluctuations in claims experience.

Remember:

Expected claims ≠ Actual claims

Suppose expected claims next year are:

RM15 million

But actual claims could become:

RM20 million

or:

RM25 million

because of unexpected adverse events.

If previous surpluses were retained, the PRF has additional resources to absorb the higher claims.

Therefore:

Retained Surplus → Stronger PRF → Greater Ability to Absorb Claims Volatility

5. Example - Distribute Everything vs Retain Surplus

Suppose the PRF has:

RM5 million surplus

Situation A - Distribute Everything

The entire:

RM5m

is distributed.

PRF retained surplus:

RM0

Next year an unexpectedly large claim produces an additional:

RM4m requirement

The PRF has no accumulated surplus available to absorb it.

This increases the possibility of:

PRF deficit → Qard requirement

Situation B - Retain RM4 Million

Suppose the actuary recommends:

Distribute RM1m

and

Retain RM4m

Next year there is an unexpected:

RM4m adverse claims experience

The accumulated RM4m can help absorb that adverse experience.

Therefore:

Retaining surplus today can protect participants against claims tomorrow.

6. What Does “Margin Against Fluctuation in Claims Experience” Mean?

This is closely related to your earlier question about margin.

Claims do not remain exactly the same every year.

For example:

Year 1 claims = RM5m

Year 2 = RM7m

Year 3 = RM6m

Year 4 = RM15m

Year 5 = RM8m

The sudden RM15m year illustrates claims volatility.

Therefore, the PRF needs some financial cushion.

Accumulated surplus can provide part of this cushion.

So:

Claims Volatility → Need for Financial Buffer → Retain Appropriate Surplus

7. Important - This Is Related to, but Different From, a Pricing Margin

You previously studied margin in pricing.

We should distinguish the two ideas.

Pricing Margin

Included when determining an appropriate contribution or risk price.

It is forward-looking.

For example:

Expected claims = RM700

Pricing margin = RM100

Required claims-related pricing allowance = RM800

Retained Surplus as a Buffer

This arises after actual experience has produced a surplus.

Instead of distributing the entire surplus, some is retained in the PRF to strengthen the fund against future adverse claims.

For example:

Actual underwriting surplus = RM5m

Actuary recommends retaining = RM4m

Distributable amount = RM1m

So both provide protection against uncertainty, but they arise at different stages.

8. The Actuary Must Protect Future Claim-Paying Ability

The most important consideration is:

Will the PRF still be capable of paying future claims after the surplus distribution?

Suppose:

PRF assets/resources = RM100m

Potential surplus = RM10m

The operator wants to distribute the entire RM10m.

But actuarial analysis indicates that the PRF needs approximately:

RM96m

to maintain an appropriate financial position for its future obligations and risks.

If RM10m were distributed:

RM100m − RM10m = RM90m

But the PRF needs:

RM96m

Therefore, distributing RM10m could weaken the PRF excessively.

The actuary may therefore conclude that the full RM10m should not be distributed.

9. The Actuary May Recommend Only Part of the Surplus

Suppose:

Total surplus = RM10m

Based on claims volatility and future obligations, the actuary determines that:

RM7m should remain in PRF

Therefore:

Potential distributable surplus:

RM10m − RM7m = RM3m

So:

Total Surplus ≠ Distributable Surplus

This is a very important distinction.

10. What Is “Distributable Surplus”?

Distributable surplus means the portion of the available surplus that can appropriately be distributed under the applicable rules without weakening the PRF’s ability to meet its obligations.

For example:

Total underwriting surplus = RM8m

Required amount to be retained = RM5m

Potential distributable amount = RM3m

Therefore:

RM8m surplus does not necessarily mean RM8m distribution.

The actuary’s assessment is crucial.

11. Malaysia - Actuarial Assessment Before Distribution

Under the Malaysian regulatory approach described here, surplus distribution is subject to an actuarial assessment.

The actuary needs to be satisfied that the proposed distribution will not jeopardise future claim payments from the risk fund.

In simple terms:

Participants should not receive a large surplus distribution today if doing so could leave insufficient resources to pay participants’ claims tomorrow.

This reflects the principle of financial prudence.

12. Why Must the Accounts Be Audited?

The accounts should also be audited before surplus is distributed.

Why?

Because before distributing money, there should be sufficient confidence that the reported financial position is reliable.

Suppose management calculates:

Surplus = RM10m

But after proper review, it is discovered that:

RM3m of claims had not been properly recognised.

The true position may be substantially different.

Therefore, auditing provides additional assurance over the financial information used in determining the surplus.

13. Actuary and Auditor Have Different Roles

Do not confuse the two.

Actuary

Focuses heavily on matters such as:

claims liabilities

future uncertainty

claims volatility

financial adequacy

and

whether surplus distribution is prudent.

Auditor

Examines whether the financial statements are appropriately prepared and presented according to the relevant financial reporting framework.

Therefore:

Actuarial Assessment + Audited Accounts → Stronger Basis for Surplus Distribution

14. Claims Volatility Is Extremely Important

The more volatile the claims experience, the more cautious the actuary is likely to be about surplus distribution.

Why?

Because:

High volatility = Greater uncertainty about future claims

Suppose two PRFs each have:

RM5m surplus

But their claims histories are very different.

PRF A

Claims:

RM10m → RM10.5m → RM9.8m → RM10.2m → RM10.4m

Claims are relatively stable.

PRF B

Claims:

RM5m → RM18m → RM7m → RM25m → RM6m

Claims are highly volatile.

Although both currently have RM5m surplus, the actuary may be much more cautious about distributing PRF B’s surplus.

15. Why?

Because PRF B has demonstrated that a:

“Big claim”

or bad claims year can arise unexpectedly.

If the entire RM5m is distributed today and a major claim occurs next year, the PRF could fall into deficit.

Therefore:

Greater Claims Volatility

↓

Greater Need for Buffer

↓

Greater Surplus Retention

↓

Less Likely/Less Amount to Be Distributed

16. What Does “Save It for the Next Big Claim” Mean?

Suppose:

Year 1 surplus retained = RM2m

Year 2 surplus retained = RM3m

Year 3 surplus retained = RM2m

Accumulated surplus:

RM2m + RM3m + RM2m = RM7m

Now in Year 4, an unexpectedly bad claims year creates an additional:

RM6m adverse claims experience

The PRF has:

RM7m accumulated surplus

available as a financial buffer.

Therefore, the fund is much better positioned to absorb the bad year.

This is the benefit of surplus accumulation.

17. Retaining Surplus Can Reduce Dependence on Qard

This connects directly with what you studied earlier.

Suppose the PRF has no accumulated surplus.

Unexpected adverse claims create:

RM5m deficit

The shareholder/operator fund may have to provide:

RM5m qard, depending on the applicable arrangement.

But suppose the PRF had previously accumulated:

RM6m retained surplus

The RM5m adverse experience may be absorbed by the PRF’s own accumulated resources.

Therefore:

Retained Surplus → Stronger PRF → Lower Reliance on Qard

This supports the mutual nature of Takaful.

18. Risk Sharing Is Not Only Between Participants in the Same Year

This is one of the most important ideas here.

Normally, when we think about Takaful risk sharing, we imagine:

Ahmad + Ali + Sarah + Fatimah

all contributing to the PRF in the same year.

If Ahmad suffers a covered loss, the common fund pays Ahmad’s claim.

That is:

Risk sharing among current participants.

But Takaful risk sharing can also extend across time through the accumulation of the PRF.

19. Risk Sharing Between Different Years

Imagine:

Year 1

10,000 participants contribute.

Claims are low.

Surplus retained:

RM3m

Year 2

Another group of participants contributes.

Claims are also relatively low.

Additional surplus retained:

RM2m

Accumulated surplus:

RM5m

Year 3

Participants experience unusually high claims.

The PRF needs an additional:

RM4m

The accumulated RM5m from earlier years can help absorb the Year 3 claims.

Therefore, resources built up when earlier participants experienced favourable claims can support the risk pool when later participants experience unfavourable claims.

This creates an intertemporal dimension of risk sharing.

20. What Is Intertemporal Risk Sharing?

Intertemporal simply means:

Across different periods of time.

So Takaful risk sharing can occur:

Horizontally

Among many participants within the same period.

and

Intertemporally

Through the PRF’s accumulated resources across different years.

For example:

Current Participants → Build PRF Surplus → Retain Surplus → Future Participants/Claims Benefit

This is why distributing every surplus immediately may weaken the long-term mutual risk-sharing function.

21. Important Clarification

This does not mean that every future participant personally owns the surplus generated by previous participants.

The exact ownership, eligibility for distribution and treatment of surplus depend on the applicable Takaful model, certificate terms and regulatory/Shari’ah framework.

The important economic concept is:

Retaining appropriate surplus allows the PRF to absorb fluctuations across different periods rather than treating each year as completely isolated.

22. Why This Makes the PRF Stronger

Suppose the PRF distributes every surplus immediately.

The pattern becomes:

Good year → Distribute everything

Bad year → Deficit

Good year → Distribute everything

Bad year → Deficit

This creates instability.

A more prudent approach may be:

Good year → Retain appropriate surplus

↓

Another good year → Build additional buffer

↓

Bad year → Use accumulated buffer

↓

PRF remains stronger.

Therefore:

Surplus Accumulation Smooths Claims Volatility Across Time

23. The Actuary’s Decision Process

The actuary essentially considers:

Is there an actual surplus?

↓

What future claims and liabilities exist?

↓

How volatile are claims?

↓

How strong is the PRF?

↓

How much financial buffer should remain?

↓

Would distribution jeopardise future claims?

↓

If safe:

Recommend an appropriate distributable amount

If not safe:

Retain surplus in PRF

24. Three Possible Outcomes

Suppose total surplus is:

RM10 million

The actuary might conclude:

Outcome 1 - Full Distribution

If financial conditions are sufficiently strong under the applicable rules:

Distribute RM10m

Outcome 2 - Partial Distribution

For example:

Distribute RM3m

Retain RM7m

Outcome 3 - No Distribution

If claims volatility and future obligations are too uncertain:

Distribute RM0

Retain RM10m

Therefore:

Having a surplus does not create an automatic right to immediate full distribution.

25. Connection With Solvency

Surplus distribution and solvency are directly connected.

If too much surplus is distributed:

PRF resources ↓

↓

Financial buffer ↓

↓

Ability to absorb unexpected claims ↓

↓

Probability of deficit ↑

↓

Potential qard dependence ↑

Therefore, actuarial oversight helps ensure that surplus distribution does not undermine the financial sustainability of the PRF.

Easy Way to Remember

Use:

SURPLUS → CHECK → RETAIN → DISTRIBUTE

SURPLUS

Determine whether a genuine surplus exists.

CHECK

Actuary assesses future claims, volatility and financial strength.

RETAIN

Keep enough surplus in the PRF as a buffer.

DISTRIBUTE

Only the amount that can prudently be distributed should be considered for distribution according to the applicable rules.

Simple Formula

A useful conceptual formula is:

Total Surplus − Required Retained Buffer = Potential Distributable Surplus

For example:

RM10m − RM7m = RM3m

Therefore:

Total surplus = RM10m

does not necessarily mean:

Distribution = RM10m

It could mean:

RM7m retained + RM3m distributed

depending on actuarial assessment and applicable requirements.

Relationship With Claims Volatility

The principle can be remembered as:

Higher Claims Volatility → Greater Need for Retained Surplus → Lower Likelihood/Amount of Distribution

Conversely, relatively stable claims may give the actuary greater confidence, although other financial factors still need to be considered.

Relationship With Risk Sharing

Within the Current Year

Many Current Participants → Common PRF → Claims of the Few

Across Different Years

Current Surpluses → Retained in PRF → Future Claims

Therefore:

Takaful risk sharing can operate both among participants in the same period and across different periods through the accumulation of the risk fund.

One-Sentence Summary

The actuary determines not only whether the Participants’ Risk Fund has a surplus but also whether any of that surplus can safely be distributed, how much should be retained as a buffer against future claims volatility, and the appropriate distribution under the applicable rules; greater claims volatility generally supports greater surplus retention because accumulated surplus strengthens the PRF, protects future claim-paying ability and enables risk sharing across different periods.

Takaful - Regulation and Supervision of Takaful

Regulation and supervision of Takaful aim to ensure that Takaful operators understand the risks they are managing, maintain sufficient resources to manage those risks, treat participants fairly, remain financially sound, and operate in accordance with Shari’ah requirements.

The central regulatory principle is:

First identify and allocate the risks → then ensure sufficient resources are available to manage those risks.

Importantly, resources do not mean capital alone. They also include competent people, appropriate IT systems, governance and other operational capabilities.

1. First Principle - Determine Where the Risks Are

Before deciding how much capital or other resources are required, the regulator must understand:

What risks exist, and who bears those risks?

This is particularly important in Takaful because different risks may be borne by different parties or funds.

For example:

Participants’ Risk Fund (PRF) bears the participants’ underwriting risk.

The Takaful operator manages the Takaful operation and faces operational, management and other business risks.

The shareholder/operator fund provides the operator’s financial resources and may support the PRF through qard where applicable.

Therefore, regulation should recognise the fund structure and allocation of risks rather than treating every risk as if it belonged to the same party.

2. Example - Allocation of Underwriting Risk

Suppose:

PRF underwriting income/resources = RM20 million

Relevant claims and obligations = RM25 million

Therefore:

RM20m − RM25m = −RM5m

The PRF has:

RM5 million underwriting deficit

The underwriting risk belongs primarily to the participants collectively through the PRF, rather than automatically becoming an underwriting loss of the operator’s shareholders.

The regulator therefore needs to determine:

Who bears the risk?

before deciding:

What resources are required and where should those resources be maintained?

3. Regulation Is Not Only About Capital

When we hear:

“The Takaful operator must have sufficient resources.”

we might immediately think of:

Money or capital.

But regulatory resources are much broader.

They include:

Financial capital

Competent and appropriately trained employees

Actuaries

Underwriters

Claims personnel

Risk-management personnel

Shari’ah expertise

IT systems

Data and cybersecurity infrastructure

and

appropriate governance systems

Therefore:

Financial strength without operational capability is not sufficient.

4. Why Are Human Resources Important?

Suppose a Takaful operator has:

RM500 million capital

but its underwriters are poorly trained.

They repeatedly accept high-risk participants at inadequate contributions.

This could result in:

Poor underwriting

↓

Inadequate pricing

↓

Excessive claims

↓

PRF deficits

↓

Financial pressure

Therefore, having a large amount of capital does not compensate indefinitely for poor management.

A Takaful operation needs both:

Financial Resources + Competent Human Resources

5. Why Are IT Systems Important?

Modern Takaful operators may manage thousands or millions of:

participants

contributions

claims

certificates

investments

and

financial transactions.

Suppose an operator has adequate capital but a poor IT system that cannot accurately track:

participant contributions

claims

PRF balances

or

investment allocations.

This creates significant operational risk.

Therefore:

Capital + Skilled People + Reliable Systems = Stronger Risk Management

6. Risk-Based Capital

An important regulatory approach is Risk-Based Capital (RBC).

The basic principle is:

The amount of capital required should reflect the amount and nature of risk being taken.

Therefore:

Higher risk → Generally higher required capital

Lower risk → Generally lower required capital

This is more meaningful than requiring every Takaful operator to maintain exactly the same amount of capital regardless of its risk profile.

7. Simple Risk-Based Capital Example

Suppose:

Takaful Operator A

Required capital = RM100 million

Available capital = RM180 million

Takaful Operator B

Required capital = RM300 million

Available capital = RM320 million

At first, Operator B appears stronger because:

RM320m > RM180m

But this is misleading because Operator B also carries much greater risk.

We therefore compare:

Available Capital ÷ Required Capital

8. Risk-Based Capital Ratio

A simplified formula is:

Capital Adequacy Ratio = Available Capital ÷ Required Capital × 100%

For Operator A:

RM180m ÷ RM100m × 100 = 180%

For Operator B:

RM320m ÷ RM300m × 100 ≈ 107%

Therefore, even though Operator B has more capital in absolute terms, its capital position relative to its risks is much tighter.

This is the purpose of a risk-based approach.

Do not look only at how much capital exists. Compare the available capital with the amount of capital required for the risks being taken.

9. Why Does the Regulator Monitor This Ratio?

Suppose an operator’s capital ratio changes:

Year 1 = 200%

Year 2 = 175%

Year 3 = 145%

Year 4 = 120%

The ratio is progressively deteriorating.

The regulator should not necessarily wait until:

Capital = RM0

or until the operator becomes unable to meet its obligations.

Instead, if the ratio falls to a predetermined regulatory intervention level, this acts as an early warning.

The regulator may then take appropriate supervisory action.

10. Why Is Early Regulatory Intervention Important?

The objective of risk-based supervision is to detect financial weakness before it becomes a severe solvency problem.

The process is:

Risk increases

↓

Required capital increases or available capital falls

↓

Capital ratio decreases

↓

Predetermined regulatory level reached

↓

Regulatory intervention

↓

Corrective action

Therefore:

The regulator tries to identify problems early rather than waiting until the Takaful operation fails.

11. Regulation Also Protects Participants

Regulation is not only concerned with financial solvency.

It also aims to ensure that participants are treated fairly.

This can include:

appropriate product design

clear disclosure

fair pricing

proper sales practices

protection against mis-selling

fair claims handling

and

management of conflicts of interest.

This directly connects with the earlier issue of product mis-selling risk.

12. What Happens If the Operator Treats Participants Unfairly?

The regulator may impose appropriate supervisory measures or sanctions under the applicable regulatory framework.

For example, suppose an operator systematically allows intermediaries to tell participants:

“This Family Takaful product guarantees a particular investment return.”

But the return is actually non-guaranteed.

Participants may purchase the product based on incorrect information.

This creates:

Misrepresentation

↓

Participant misunderstanding

↓

Mis-selling

↓

Unfair customer treatment

The regulator may therefore take action against the operator.

13. But Regulation Can Become Excessive

There needs to be a balance.

Too little regulation can result in:

mis-selling

poor underwriting

inadequate capital

unfair fees

weak governance

and potentially:

financial failure.

However, excessively restrictive regulation can create another problem:

It may stifle innovation.

This means Takaful operators may find it difficult or uneconomic to develop new products, technologies, distribution methods or business models.

14. Example - Excessive Regulation and Innovation

Suppose a Takaful operator wants to introduce an innovative low-cost digital Takaful product.

The objective is to allow participants to:

join online

make contributions digitally

submit claims electronically

and

receive faster service.

But suppose the regulatory framework contains extremely rigid requirements designed only for traditional branch-based operations.

The cost of complying with those requirements may make the new digital product economically unattractive.

Therefore:

Excessive Regulation

↓

Higher Compliance Burden

↓

Reduced Innovation

The regulator therefore needs to achieve:

Participant Protection + Financial Stability + Room for Appropriate Innovation

15. Fair Treatment Does Not Mean Charging the Lowest Fee

This is a particularly important point.

The requirement to:

“Treat participants fairly”

should not automatically be interpreted as:

“The Takaful operator must charge the lowest possible fee.”

The operator needs sufficient income to operate sustainably.

The Wakalah fee may support activities such as:

staff salaries

underwriting

claims administration

IT systems

distribution

regulatory compliance

Shari’ah governance

and other operating expenses.

Therefore:

A low fee is not automatically a fair fee.

The appropriate question is whether the fee is reasonable, transparent and consistent with the services and responsibilities undertaken by the operator.

16. Example - Lowest Fee Is Not Necessarily Better

Suppose:

Operator A

Wakalah fee = RM200

This allows the operator to maintain:

competent staff

good claims service

strong IT systems

proper underwriting

and

appropriate governance.

Operator B

Wakalah fee = RM80

The fee appears more attractive to participants.

But suppose RM80 is insufficient to maintain proper operations.

As a result:

service deteriorates

staff quality falls

IT investment is inadequate

and

risk management weakens.

Therefore:

Fair treatment should focus on value and appropriate treatment, not simply the lowest possible fee.

17. Supply Side and Demand Side

A sustainable Takaful industry requires appropriate incentives on both the supply side and demand side.

Supply Side - Takaful Operator

The operator supplies the Takaful service.

It expects to earn a:

Reasonable return on the capital and resources employed.

Investors provide:

capital

technology

management expertise

and other resources.

If the business cannot generate a reasonable sustainable return, investors may become unwilling to provide those resources.

Demand Side - Participants

Participants demand Takaful products.

They expect to receive:

appropriate protection

reasonable costs

and, where applicable,

savings and investment benefits.

Therefore:

Operator wants reasonable return

while:

Participant wants cost-effective protection and savings

A successful Takaful structure should try to satisfy both objectives sustainably.

18. The Interests Must Be Balanced

Suppose the operator charges extremely high fees.

Then:

Operator return ↑

but:

Participant value ↓

Participants may stop purchasing the product.

Now consider the opposite situation.

Suppose fees are forced to extremely low levels.

Then:

Participant cost may initially ↓

but:

Operator sustainability ↓

The operator may eventually reduce:

staff

technology

service quality

or

product innovation.

Therefore:

Reasonable Operator Return + Cost-Effective Participant Protection = More Sustainable Takaful

This connects directly with the principle of alignment of stakeholder interests.

19. A Holistic Approach to Takaful

A holistic approach means looking at the entire Takaful system rather than concentrating on only one component.

The system includes:

Participants

Participants’ Risk Fund

Takaful operator

Shareholders

Management

Intermediaries

Shari’ah governance

Retakaful

Investments

Technology

and

Regulators.

For example, simply forcing contributions to be very low may appear beneficial to participants.

But if:

Contribution too low

↓

Insufficient tabarru’

↓

PRF deficit

↓

Greater qard dependence

↓

Financial weakness

then the low contribution was not necessarily beneficial in the long term.

Therefore:

Takaful regulation should consider the entire system and its long-term sustainability.

20. International Association of Insurance Supervisors (IAIS)

Insurance regulators can look to the International Association of Insurance Supervisors (IAIS) for an internationally recognised framework for insurance supervision.

An important part of this framework is the:

Insurance Core Principles (ICPs)

These provide principles, standards and guidance relating to the regulation and supervision of the insurance sector.

The broad idea is:

IAIS provides an internationally recognised foundation that regulators can consider when developing their insurance supervisory frameworks.

21. What Are Insurance Core Principles?

The Insurance Core Principles (ICPs) provide a broad international framework covering important areas of insurance regulation and supervision.

They help regulators establish appropriate standards concerning matters such as insurance supervision and risk management.

The important concept to remember is:

IAIS → General international insurance supervisory framework

However, Takaful has additional structural and Shari’ah considerations.

Therefore, conventional insurance supervisory principles alone may not address every Takaful-specific issue.

22. Role of the IFSB

The Islamic Financial Services Board (IFSB) provides standards and guidance relevant to Islamic financial services, including Takaful.

For Takaful, its guidance covers areas such as:

solvency

and

risk management.

Therefore, regulators can consider:

IAIS

for the broader insurance regulatory and supervisory framework,

together with:

IFSB

for guidance addressing Islamic financial services and Takaful-specific considerations.

So:

IAIS + IFSB → Useful regulatory guidance for Takaful supervision

23. Why Can’t One Country Simply Copy Another Country’s Takaful Regulations?

A regulatory framework that works successfully in one jurisdiction may not automatically work in another.

Countries can differ in:

legal systems

market size

financial development

Takaful industry maturity

available Islamic investment instruments

consumer behaviour

business structures

and

Shari’ah governance frameworks.

Therefore:

Regulation should be adapted to the local business environment rather than copied mechanically from another jurisdiction.

24. Example - Same Regulation, Different Business Environment

Suppose Country A has a highly developed Islamic capital market containing:

many Sukuk

Islamic money-market instruments

and

Shari’ah-compliant equities.

Its Takaful operators therefore have many investment choices.

Now suppose Country B has a much smaller Islamic capital market with very few suitable Shari’ah-compliant investment instruments.

If Country B simply copies Country A’s investment rules, Takaful operators in Country B may face:

excessive concentration

liquidity problems

or

difficulty complying with the requirements.

Therefore:

Same Regulation + Different Environment = Potentially Different Outcome

Regulations need to reflect local circumstances.

25. Local Shari’ah Interpretation Must Also Be Considered

Takaful regulation has an additional dimension:

Shari’ah interpretation

Different jurisdictions may adopt different Shari’ah governance approaches or interpretations regarding certain fiqh al-muʿāmalāt issues.

Fiqh al-muʿāmalāt broadly refers to Islamic jurisprudence concerning transactions and commercial dealings.

These issues can affect matters such as:

Wakalah

Mudarabah

tabarru’

qard

investment structures

surplus arrangements

and other financial transactions.

Therefore, when a regulatory approach is transferred from one jurisdiction to another, regulators need to consider whether it is compatible with the applicable local Shari’ah framework.

26. Does Shari’ah Compliance Mean Regulation Can Be Less Prudent?

No.

This is an extremely important point.

Shari’ah constraints should not be used as an excuse to reduce:

solvency standards

risk-management standards

participant protection

or

financial discipline.

Instead, Takaful regulation must achieve both objectives simultaneously:

Prudential Soundness

and

Shari’ah Compliance

Therefore:

Shari’ah Compliance ≠ Weaker Financial Regulation

Instead:

Prudent Regulation + Shari’ah Compliance = Sound Takaful Regulation

The Whole Regulatory Process

You can understand the entire topic as one chain:

Identify Risks

↓

Determine Who Bears Each Risk

↓

Require Appropriate Resources

↓

Capital + Skilled People + IT Systems + Governance

↓

Monitor Risk-Based Capital

↓

Early Intervention When Financial Position Weakens

↓

Protect Participants

↓

Require Fair Treatment

↓

Maintain Sustainable Operator Incentives

↓

Avoid Excessively Restrictive Regulation

↓

Use IAIS + IFSB Guidance

↓

Adapt Regulation to Local Business and Shari’ah Environment

↓

Sound and Sustainable Takaful Industry

Easy Way to Remember

RISK – RESOURCES – PROTECT – BALANCE – ADAPT

RISK

Identify the risks and determine who bears them.

RESOURCES

Ensure sufficient capital, skilled people, technology and systems.

PROTECT

Protect participants through fair-treatment and prudential requirements.

BALANCE

Protect participants while allowing the operator to remain sustainable and encouraging appropriate innovation.

ADAPT

Use international guidance but adapt regulation to the local business environment and applicable Shari’ah framework.

Simple Formula

The basic regulatory principle is:

Risk Exposure → Required Resources

For capital:

Greater Risk → Generally Greater Required Capital

A simplified capital monitoring ratio is:

Available Capital ÷ Required Capital × 100% = Capital Adequacy Ratio

If the ratio falls toward a predetermined regulatory intervention level:

Early Warning

↓

Regulatory Intervention

↓

Corrective Action

↓

Reduced Risk of Financial Failure

Most Important Concept

Takaful regulation should not focus only on:

“How much capital does the operator have?”

A sound Takaful operation requires:

Capital

• ●

Competent Human Resources

• ●

Strong IT Systems

• ●

Risk Management

• ●

Fair Participant Treatment

• ●

Appropriate Pricing

• ●

Good Governance

• ●

Shari’ah Compliance

Therefore:

Capital is only one part of the resources required for a safe and sustainable Takaful operation.

One-Sentence Summary

Regulation and supervision of Takaful begin by identifying and allocating risks and then ensuring sufficient financial, human and technological resources are available to manage those risks; regulators must also protect participants, monitor solvency, maintain appropriate incentives for operators, avoid unnecessarily restricting innovation, and use international guidance such as IAIS and IFSB in a way that is appropriate to the local business environment and applicable Shari’ah framework.

Takaful - Regulatory Requirements Regarding Different Aspects of Takaful

The table compares several regulatory requirements for Takaful across six jurisdictions:

Malaysia, Bahrain, United Arab Emirates (UAE), Indonesia, Sudan, and Saudi Arabia.

The main idea is that although Takaful operates according to Shari’ah principles, different countries regulate Takaful differently. Some requirements are common across almost all jurisdictions, while others differ substantially.

1. Requirement to Treat Customers Fairly

All six jurisdictions in the table indicate Yes for the requirement to treat customers fairly.

This means Takaful operators and intermediaries are expected to ensure that participants are treated properly throughout the relationship.

This can include matters such as:

fair product design

proper disclosure

appropriate sales practices

fair pricing

proper handling of claims

and

protection against mis-selling

The table therefore shows:

Malaysia – Yes

Bahrain – Yes

UAE – Yes

Indonesia – Yes

Sudan – Yes

Saudi Arabia – Yes

Why Is Fair Treatment Important in Takaful?

Participants may not fully understand complicated Takaful products.

For example, Ahmad purchases a Family Takaful product.

The intermediary should properly explain:

what is covered

what is excluded

how much Ahmad contributes

how much is allocated as fees

how the savings/investment component works

and

what benefits are guaranteed or non-guaranteed

The intermediary should not exploit Ahmad’s lack of financial knowledge.

This connects directly with the product mis-selling risk you studied earlier.

Easy formula:

Clear Information + Fair Selling + Suitable Product + Fair Claims Handling = Fair Treatment of Participants

2. Certification of Takaful Pricing

Another regulatory issue is whether the pricing of Takaful products must be certified.

According to the table:

Malaysia – Yes

Bahrain – No

UAE – Yes

Indonesia – Yes

Sudan – No

Saudi Arabia – Yes

This requirement is important because Takaful contributions should be priced appropriately for the risks being accepted.

Why Is Pricing Certification Important?

Remember what you studied earlier:

If a Takaful product is underpriced, the contribution may be insufficient.

Suppose actuarial analysis indicates that the PRF requires:

Expected claims = RM700

Appropriate margin = RM100

Therefore:

Required PRF amount = RM800

But because the product is underpriced, only:

RM600

is allocated to the PRF.

There is potentially:

RM200 inadequate funding per participant.

If this happens across thousands of participants:

Underpricing → Insufficient Tabarru’ → PRF Deficit → Greater Solvency Pressure

Therefore, appropriate pricing requirements help protect the financial sustainability of the PRF.

3. Connection With the Agent-Principal Conflict

Pricing regulation is also important because of the Wakalah fee conflict you studied.

Suppose the operator receives:

20% of contributions as Wakalah fee.

The operator might benefit from:

More participants → More contributions → Higher total Wakalah fees

But if more participants are attracted through deliberately low pricing, the PRF may become underfunded.

Therefore:

Operator benefits from higher turnover

while:

Participants may suffer through PRF deficits.

Proper pricing governance helps reduce this conflict.

4. Requirement for Shari’ah Certification of Operations

Takaful is not merely conventional insurance with different terminology.

Its operations must comply with relevant Shari’ah requirements.

According to the table:

Malaysia – Yes

Bahrain – Yes

UAE – Yes

Indonesia – Yes

Sudan – Yes

Saudi Arabia – No

The table therefore shows that most of the jurisdictions examined expressly require Shari’ah certification of Takaful operations, although the regulatory structures differ.

What Does Shari’ah Certification Mean?

It means the Takaful operation needs appropriate Shari’ah oversight to ensure that its structure and activities comply with applicable Shari’ah principles.

This may concern matters such as:

Takaful contracts

tabarru’ arrangements

Wakalah arrangements

Mudarabah arrangements

investment activities

surplus treatment

qard

and

Retakaful arrangements.

5. Why Is Shari’ah Certification Important?

Imagine a Takaful operator collects participants’ savings and then invests them in prohibited interest-bearing instruments.

Even if the operator has:

good underwriting

good claims management

and

strong financial performance

there would still be a Shari’ah compliance problem.

Therefore, Takaful needs both:

Financial soundness

and

Shari’ah compliance.

A successful Takaful operation cannot focus on only one and ignore the other.

Easy formula:

Sound Takaful = Financial Sustainability + Shari’ah Compliance

6. Existence of a National Supreme Shari’ah Decision-Making Body

This requirement concerns whether the jurisdiction has a national-level Shari’ah authority or decision-making body relevant to the industry.

According to the table:

Malaysia – Yes

Bahrain – No

UAE – No

Indonesia – Yes

Sudan – Indirectly, Yes

Saudi Arabia – No

This shows an important difference in Shari’ah governance architecture between jurisdictions.

7. Why Have a National Shari’ah Body?

Suppose:

Takaful Operator A’s Shari’ah committee says a particular structure is permissible.

But:

Takaful Operator B’s Shari’ah committee says it is impermissible.

If every institution operates completely independently, inconsistent Shari’ah interpretations may arise.

A national-level Shari’ah authority can help provide greater:

consistency

standardisation

certainty

and

coordination

within the financial system, depending on the jurisdiction’s governance model.

8. Institutional Shari’ah Committee vs National Shari’ah Body

Do not confuse these two.

Institutional Shari’ah Committee

Operates at the level of the individual Takaful operator or financial institution.

Its role is to oversee the institution’s Shari’ah compliance according to the applicable framework.

National Shari’ah Body

Operates at a broader national or regulatory level.

It may provide centralised Shari’ah rulings, standards or guidance depending on the jurisdiction.

Therefore:

Institutional Shari’ah Governance = Individual institution

while:

National Shari’ah Governance = Broader financial system

9. Limitation on Commissions to Intermediaries

The table also considers whether there are limitations on commissions paid to Takaful intermediaries.

According to the table:

Malaysia – Yes

Bahrain – No

UAE – No

Indonesia – No

Sudan – No

Saudi Arabia – Yes

This issue is closely related to product mis-selling and conflicts of interest.

10. Why Can Intermediary Commission Be a Problem?

Suppose an agent can recommend either Product A or Product B.

Product A gives the agent:

RM200 commission

Product B gives:

RM1,000 commission

But Product A is more suitable for Ahmad.

The agent may nevertheless be tempted to recommend Product B because:

Product B → Higher commission

This creates a:

Conflict of interest

The intermediary’s interest becomes:

Maximise commission

while the participant’s interest is:

Obtain the most appropriate protection/product

These interests may conflict.

11. Connection With Mis-Selling

This connects directly with the previous topic.

A poorly designed commission structure can produce:

Higher Commission

↓

Agent incentive to sell particular product

↓

Customer needs potentially ignored

↓

Unsuitable product sold

↓

Mis-selling risk

Therefore, regulation of intermediary remuneration can form part of the broader framework for protecting participants.

12. Solvency Requirements

This is one of the most consistent requirements in the table.

All six jurisdictions are marked Yes:

Malaysia – Yes

Bahrain – Yes

UAE – Yes

Indonesia – Yes

Sudan – Yes

Saudi Arabia – Yes

This reflects the fundamental importance of financial strength.

13. What Does Solvency Mean?

Solvency broadly refers to having sufficient financial resources to meet financial obligations.

For Takaful, the arrangement must be capable of meeting valid participant claims and other relevant obligations.

For example:

Suppose the PRF has:

RM100 million

but expected claims and relevant obligations amount to:

RM130 million

There is potentially a serious financial problem.

Therefore, regulators impose financial requirements intended to reduce the risk that a Takaful operation cannot meet its obligations.

14. Why Is Solvency Especially Important?

Remember:

Participants pay contributions before many claims occur.

Ahmad might pay his contribution:

today

but make a claim:

six months later.

Therefore, the Takaful arrangement must remain financially sound between:

Contribution received → Claim eventually occurs

This is why Takaful operators cannot simply focus on today’s sales.

They need to ensure long-term financial sustainability.

15. Connection With Your Previous Capital Topic

You previously studied:

Risk pooling

PRF surplus

PRF deficit

qard

capital

Retakaful

and

solvency

They are all connected.

A financially strong Takaful arrangement may rely on:

Proper Pricing

• ●

Adequate Tabarru’

• ●

Good Underwriting

• ●

Diversification

• ●

Appropriate Reserves

• ●

Retakaful

• ●

Accumulated Surplus

• ●

Capital/Qard support where applicable

to maintain financial strength.

16. Regulation of Investment of Takaful Assets

The final requirement shown concerns the investment of Takaful assets.

According to the table:

Malaysia – Yes

Bahrain – Yes

UAE – Yes

Indonesia – Yes

Sudan – Yes

Saudi Arabia – Yes

So all six jurisdictions shown regulate investment of Takaful assets.

17. Why Must Takaful Investments Be Regulated?

Takaful operators manage significant amounts of money.

Depending on the Takaful structure, this can include:

Participants’ Risk Fund assets

participants’ savings/investment funds

and

shareholder/operator fund assets.

The operator should not simply invest these funds in extremely risky assets in an attempt to obtain very high returns.

Investment management needs to consider:

Shari’ah compliance

safety

liquidity

diversification

return

solvency

and

regulatory requirements.

18. Example - Why Investment Regulation Matters

Suppose a PRF has:

RM100 million

The operator invests the entire RM100m into one highly risky and illiquid investment.

Then suddenly:

RM30 million of claims

must be paid.

Even if the investment might eventually generate a good return, the PRF could face a serious liquidity problem because the money cannot easily be converted into cash.

Therefore:

A good investment is not judged only by its return.

It must also consider:

Risk + Liquidity + Shari’ah Compliance + Solvency

19. Connection With Claims

Remember your recent question:

“Where does an insurer get money to pay claims?”

Takaful funds also hold assets.

Therefore, investment management must ensure sufficient assets are available or sufficiently liquid to meet claims when they become due.

For example:

PRF assets = RM100m

Expected near-term claims = RM20m

The operator should not lock the entire RM100m into investments that cannot be converted into cash when those claims need to be paid.

This is called liquidity management.

20. The Major Pattern in the Table

There are two requirements for which all six jurisdictions are marked Yes:

Fair treatment of customers

and

Solvency requirements

and the table also shows all six as regulating:

Investment of Takaful assets.

Other areas show more variation, particularly:

pricing certification

national Shari’ah governance

and

intermediary commission limitations.

This demonstrates that:

The broad objectives of Takaful regulation may be similar, but the regulatory mechanisms used to achieve them can differ between jurisdictions.

Easy Way to Remember

Remember:

CUSTOMER – PRICE – SHARI’AH – AGENT – SOLVENCY – INVESTMENT

CUSTOMER

Treat participants fairly.

PRICE

Ensure Takaful is appropriately priced.

SHARI’AH

Ensure operations comply with applicable Shari’ah requirements.

AGENT

Control intermediary conduct and conflicts of interest.

SOLVENCY

Ensure sufficient financial strength to meet obligations.

INVESTMENT

Ensure Takaful assets are invested prudently and appropriately.

How All the Regulations Connect

Fair Customer Treatment

↓

Reduces mis-selling

↓

Proper Pricing

↓

Prevents insufficient tabarru’

↓

Good Underwriting

↓

Reduces unnecessary PRF deficits

↓

Shari’ah Governance

↓

Maintains Shari’ah compliance

↓

Intermediary Regulation

↓

Reduces conflicts of interest

↓

Investment Regulation

↓

Protects fund assets and liquidity

↓

Solvency Regulation

↓

Helps ensure claims can be paid

↓

Sustainable Takaful System

One-Sentence Summary

Takaful regulation aims to protect participants and maintain a financially and Shari’ah-sound system through fair customer treatment, appropriate product pricing, Shari’ah governance, control of intermediary incentives, solvency requirements and prudent regulation of Takaful investments, although the exact regulatory approach differs between jurisdictions.

Takaful - Where Does a Conventional Insurer Get the Money to Cover Claims When Premiums Are Insufficient?

The key point is that “underwriting loss” is an accounting/economic result, not a separate bill that must be paid from one specific account.

The insurer already holds a large pool of assets. It pays claims using those available assets—especially cash and liquid investments. If the claims and expenses ultimately exceed the income earned, the resulting loss reduces the insurer’s shareholders’ equity.

⸻

Simple Example

Suppose an insurer starts the year with assets that include:

RM100 million of existing financial assets

During the year it collects:

RM20 million premiums

So, simplifying greatly, it has resources/assets of:

RM100m + RM20m = RM120m

Now suppose claims and underwriting expenses are:

RM25 million

The insurer pays the RM25m using its available cash/assets.

It does not have to find a special “RM5m loss account.”

The underwriting calculation simply tells us:

Premiums RM20m − Claims/expenses RM25m = −RM5m

So there is an:

RM5 million underwriting loss.

⸻

Where Did the Extra RM5 Million Physically Come From?

It came from the insurer’s existing assets/resources.

Those assets may include:

cash, bank deposits, bonds, other investments, accumulated earnings and capital-funded assets.

The insurer may also receive reinsurance recoveries for claims covered by reinsurance.

So physically:

Claim payment → paid from insurer’s available assets/cash

Economically:

Loss → reduces the insurer’s net assets/shareholders’ equity, unless offset by investment income or other gains.

⸻

Example With Investment Income

Suppose:

Premium income = RM20m

Claims and underwriting expenses = RM25m

Therefore:

Underwriting loss = RM5m

But the insurer earned:

Investment income = RM5m

Then, ignoring everything else:

−RM5m + RM5m = RM0

The investment income has offset the underwriting loss.

⸻

But What If There Is No Investment Income?

Suppose again:

Premiums = RM20m

Claims/expenses = RM25m

Underwriting loss = RM5m

Investment income = RM0

The insurer still pays the RM25m from its available assets.

The resulting RM5m loss reduces its net assets.

For example, if shareholders’ equity was initially:

RM100m

then, very simplistically:

RM100m − RM5m = RM95m

So when we say:

“Shareholders bear the underwriting loss”

we usually mean:

The loss reduces the net assets/equity belonging to shareholders.

It does not necessarily mean shareholders immediately take RM5m from their personal bank accounts and transfer it to the insurer.

⸻

When Do Shareholders Actually Put New Money In?

That happens if the insurer’s capital becomes inadequate and shareholders or new investors make a capital injection.

For example:

Repeated losses:

RM100m equity → RM80m → RM60m → RM40m

Suppose the insurer needs more capital to satisfy its financial and regulatory requirements.

Shareholders might inject:

RM30m new capital

Then, simplistically:

RM40m + RM30m = RM70m

That is new money actually contributed by shareholders.

⸻

Think of It Like a Business Bank Account

Imagine you start a company by putting in:

RM100,000 capital

Your company then earns:

RM20,000 revenue

but has to pay:

RM25,000 expenses

The company doesn’t necessarily call you and say:

“Please transfer RM5,000 so we can pay the bills.”

If the company already has sufficient cash/assets, it pays the RM25,000.

But financially, it made:

RM20,000 − RM25,000 = −RM5,000 loss

That RM5,000 loss reduces the owner’s equity in the business.

Insurance works on the same broad principle, although actual insurance accounting is much more complex.

⸻

So There Are Two Different Questions

Question 1: Where does the actual cash for paying the claim come from?

From the insurer’s available cash and other assets, with reinsurance recoveries also contributing where applicable.

Question 2: Who economically bears the loss if premiums and other income are insufficient?

The loss reduces the insurer’s shareholders’ equity/capital.

If losses become so large that capital is inadequate, shareholders or new investors may have to provide new capital.

⸻

Easy Way to Remember

Premiums + Existing Assets + Investment Returns + Reinsurance Recoveries

↓

Insurer has resources to pay claims

If:

Claims and expenses > relevant income

↓

Underwriting loss

If other income does not offset the loss:

↓

Net assets decrease

↓

Shareholders’ equity decreases

If losses continue:

↓

Capital may become inadequate

↓

New shareholder capital may be required

So the shortest answer is:

The insurer pays claims from its available assets. If premiums and other income are insufficient, the resulting loss reduces shareholders’ equity; shareholders only need to put in new cash if additional capital has to be injected.

Takaful - Does Investment Income Prevent Underwriting Loss From Affecting Shareholders’ Capital?

Yes, broadly you have the right idea, but there is one important correction.

If a conventional insurer has an underwriting loss, sufficient investment income or other profits can offset that loss, so shareholders’ equity may not decrease. If the loss is not sufficiently offset, the company’s overall loss reduces shareholders’ equity.

But we should not picture shareholders personally taking cash from their pockets every time claims exceed premiums.

1. Example: Underwriting Loss Fully Offset by Investment Income

Suppose:

Premium income = RM10m

Claims + underwriting expenses = RM12m

Therefore:

Underwriting result = RM10m − RM12m = −RM2m

So:

Underwriting loss = RM2m

But suppose the insurer also earns:

Investment income = RM3m

Then, simplifying heavily:

−RM2m underwriting loss + RM3m investment income = +RM1m overall profit

Therefore, despite having an underwriting loss, the insurer still makes an overall profit.

In this simplified example, shareholders’ equity is not depleted by the underwriting loss, because the investment income more than offsets it.

For example:

Starting shareholders’ equity = RM100m

Overall profit = RM1m

Ending equity ≈ RM101m

So this distinction is important:

Underwriting loss does not automatically mean overall company loss.

2. What If Investment Income Exactly Covers the Underwriting Loss?

Suppose:

Underwriting loss = −RM2m

Investment income = +RM2m

Then:

−RM2m + RM2m = RM0

Ignoring everything else:

Overall result = RM0

Starting shareholders’ equity:

RM100m

Ending shareholders’ equity:

approximately RM100m

So the investment income has offset the underwriting loss.

3. What If Investment Income Covers Only Part of the Loss?

Suppose:

Underwriting loss = −RM5m

Investment income = +RM2m

Then:

−RM5m + RM2m = −RM3m

Overall loss:

RM3m

If starting shareholders’ equity is:

RM100m

then, simplifying:

RM100m − RM3m = RM97m

So shareholders’ equity has been reduced by the net overall loss, not necessarily by the entire RM5m underwriting loss.

4. What If There Is No Investment Income?

Suppose:

Underwriting loss = RM5m

Investment income = RM0

Other income/gains = RM0

Then the simplified overall result is:

−RM5m

Starting shareholders’ equity:

RM100m

After the loss:

RM95m

So yes, economically, the loss is now being absorbed by the insurer’s existing net assets/shareholders’ equity.

5. But Is “Shareholder Money Used to Pay the Claim” Correct?

Conceptually yes, but don’t understand it too literally.

Suppose:

Premiums = RM10m

Claims = RM15m

It would be tempting to say:

“RM10m comes from premiums and the remaining RM5m is taken directly from shareholders.”

That is useful as a very simplified explanation, but it is not how we should describe the actual accounting and cash flow.

The insurer has a balance sheet containing many assets, such as:

cash

bank deposits

bonds

investments

and other assets.

It also has liabilities, including insurance claim obligations.

Shareholders’ equity represents, broadly:

Assets − Liabilities = Shareholders’ Equity

So when the insurer suffers losses, its net assets/equity are reduced.

6. A Simple “Bucket” Example

Imagine a conventional insurer has:

Assets = RM150m

Liabilities = RM50m

Therefore:

Shareholders’ equity = RM100m

Because:

RM150m − RM50m = RM100m

Now suppose the insurer suffers an overall RM10m loss.

Very simplistically, net assets fall by RM10m.

So:

Shareholders’ equity falls from RM100m → RM90m

The shareholders did not necessarily transfer a new RM10m cheque into the company.

Rather:

The value of the net assets belonging to shareholders has fallen by RM10m.

That is what “shareholders bear the loss” means.

7. When Would Shareholders Actually Need to Put New Money Into the Insurer?

This is a different situation.

Suppose repeated losses severely reduce the insurer’s capital.

Starting capital/equity:

RM100m

After several bad years:

RM30m

But suppose regulatory requirements mean the insurer needs significantly more capital to continue operating safely.

The existing shareholders, or new investors, may need to inject new capital.

For example:

Existing equity = RM30m

Additional capital injected = RM50m

New equity, simplistically:

RM80m

This is an actual capital injection.

So distinguish:

Loss absorbed by existing shareholder equity

The company’s existing net assets decline.

versus

New shareholder capital injection

Shareholders actually contribute additional money to strengthen the company.

These are not the same thing.

8. Where Does Reinsurance Fit?

There’s another important source of protection.

Suppose:

Claim = RM20m

Under the reinsurance arrangement:

Insurer bears = RM5m

Reinsurer bears = RM15m

The insurer receives the relevant reinsurance recovery, reducing the net amount it has to bear.

Therefore, you should think about conventional insurance financial protection as having several components:

Adequate Premium Pricing

• ●

Insurance Reserves/Assets

• ●

Investment Income

• ●

Reinsurance

• ●

Shareholder Capital

All contribute to the insurer’s ability to remain financially sound.

9. Very Important: Investment Income Does Not Make Underpricing Safe

Suppose an insurer deliberately underprices every year:

Underwriting loss = RM20m

Investment income = RM25m

Overall simplified profit:

RM5m

It may survive.

But next year:

Underwriting loss = RM20m

Investment income = only RM5m

Then:

Overall loss = RM15m

Investment returns are not necessarily guaranteed.

Therefore, an insurer should not deliberately maintain bad underwriting simply because:

“Our investments will cover the losses.”

Sound insurance requires appropriate pricing and underwriting as well as prudent investment management.

10. The Most Important Distinction

There are really three different questions here.

Question 1: Did the insurance business itself make money?

Look at the:

Underwriting result

If:

Premium income = RM10m

Claims + underwriting expenses = RM12m

then:

Underwriting loss = RM2m

Question 2: Did the whole insurance company make money?

Now include investment and other results.

If:

Underwriting loss = −RM2m

Investment/other net income = +RM5m

then:

Overall result = +RM3m

The company can have an underwriting loss but still have an overall profit.

Question 3: Did shareholders’ equity decrease?

That depends on the overall financial result and other movements in equity, not simply whether there was an underwriting loss.

In our simplified example:

Overall profit → equity can increase

Overall loss → equity decreases

Easy Way to Remember

Think:

UNDERWRITING RESULT

• ●

INVESTMENT RESULT

• ●

OTHER RESULTS

=

OVERALL COMPANY RESULT

Then:

If overall result is positive:

Shareholders’ equity can increase

If overall result is negative:

Shareholders’ equity decreases

If losses become very large:

Existing capital can be depleted → new capital may need to be injected

Your Two Questions, Answered Directly

“If underwriting loss is covered by investment income, shareholder capital is not affected?”

Broadly yes, if investment and other income fully offset the underwriting loss so that the company has no overall loss, then the underwriting loss by itself does not deplete shareholders’ equity. In fact, if the overall result is positive, equity can increase.

“If there is no investment income, is money from shareholders used to pay the claim?”

In a simplified economic sense, yes: if premiums and other resources are insufficient and the insurer suffers an overall loss, that loss is absorbed by the insurer’s existing net assets and reduces shareholders’ equity/capital. But it does not necessarily mean shareholders immediately inject new cash. A new capital injection occurs only when shareholders/investors actually contribute additional funds.

One line to memorise

Premiums are intended to support insurance obligations; investment income can offset underwriting losses; any remaining overall loss reduces shareholders’ equity, and if equity becomes inadequate, shareholders or other investors may need to inject new capital.

Takaful - If Claims Exceed Premiums, Where Does a Conventional Insurer Get the Money?

Yes, ultimately the insurer’s own financial resources—including capital provided by shareholders—act as the financial buffer. But there is an important nuance: the insurer does not normally keep premiums in one pot and then immediately ask shareholders for money whenever claims exceed that year’s premiums.

A conventional insurer holds assets, insurance reserves/provisions, retained earnings and shareholder capital, and may also receive recoveries from reinsurance.

1. Start With a Simple Example

Suppose a conventional insurer collects:

Premiums = RM10 million

During the year:

Claims = RM12 million

Ignoring expenses for the moment:

RM10m − RM12m = −RM2m

There is a:

RM2 million negative result from this simplified claims comparison.

But the insurer still has to pay valid covered claims.

It cannot tell policyholders:

“We collected only RM10 million, so we will only pay RM10 million of the RM12 million claims.”

The insurer has contractually accepted the insurance risk.

2. So Where Does the Extra RM2 Million Come From?

Think of the insurer as having a larger pool of financial resources than just this year’s premiums.

For example, it may have:

Premium income

• ●

Accumulated retained earnings

• ●

Investment assets/income

• ●

Shareholders’ capital

• ●

Reinsurance recoveries, where applicable

These resources support its ability to meet insurance obligations.

So, economically, if underwriting losses are not offset by other income, they reduce the insurer’s net assets/shareholders’ equity.

3. Example With Shareholders’ Capital

Suppose shareholders initially provided:

RM50 million capital

The insurer then collects:

RM10m premiums

Claims are:

RM12m

Ignoring everything else:

Underwriting shortfall = RM2m

The insurer pays the RM12m claims.

Because premiums were insufficient by RM2m, the insurer’s net financial position is reduced by RM2m.

Simplistically:

Shareholders’ equity before loss = RM50m

Underwriting loss = RM2m

Therefore:

Remaining shareholders’ equity = RM48m

So, yes, in an economic sense, the loss has eaten into shareholders’ capital/equity.

4. But Don’t Imagine a Separate “Shareholder Wallet”

This distinction is important.

It is slightly misleading to imagine:

Premium account has RM10m → claims are RM12m → company takes exactly RM2m out of a separate shareholder bank account.

Insurance accounting and asset management are more complicated than that.

The better way to understand it is:

The insurer owns/holds assets against its liabilities. If insurance operations produce losses, those losses reduce the insurer’s net assets and therefore shareholders’ equity, unless offset by other income.

So:

Underwriting Loss → Lower Net Assets/Profit → Lower Shareholders’ Equity

5. What About Insurance Reserves?

Insurers also establish insurance liabilities/reserves/provisions for expected claims.

Remember something important:

Premiums are collected before many claims are paid.

Suppose an insurer receives premiums today, but expects claims to occur over the coming months or years.

It must recognise and maintain appropriate financial provisions for those obligations.

Therefore, the insurer does not normally think:

“We received RM100m premiums, so the whole RM100m is profit.”

A significant amount is needed to support:

current and future claims obligations.

6. What About Reinsurance?

Reinsurance can also absorb part of a large claim.

Suppose the insurer covers a factory for:

RM100 million

Under its reinsurance arrangement, assume:

Insurer retains = RM20m

Reinsurer covers = RM80m

A covered RM100m loss occurs.

Simplistically:

Insurer ultimately bears = RM20m

Reinsurer recovery = RM80m

So the insurer does not necessarily have to absorb the entire RM100m from its own resources.

This is why reinsurance is an important part of an insurer’s loss-absorbing capacity and risk management.

7. What If There Is No Reinsurance?

Suppose the insurer retains the entire risk.

Premium collected = RM1m

Unexpected covered claim = RM10m

The insurer remains contractually responsible for the RM10m claim.

The RM1m premium is clearly insufficient.

The remaining financial burden has to be absorbed through the insurer’s available financial resources.

That ultimately puts pressure on:

retained earnings and shareholders’ equity/capital.

This is precisely why insurers must maintain sufficient capital.

8. Why Do Regulators Require Insurers to Have Capital?

Now you can see why capital requirements are so important.

Claims are uncertain.

An insurer might expect:

RM100m claims

but actual claims become:

RM130m

If the insurer had no financial buffer whatsoever, an unexpectedly bad claims year could make it unable to pay policyholders.

Therefore:

Capital = financial buffer against unexpected losses

The shareholders’ capital is there partly to absorb losses beyond what was expected and priced for.

9. Expected Claims vs Unexpected Claims

This distinction helps.

Expected claims

These should primarily be reflected in the premium pricing and insurance liabilities/reserves.

For example:

Expected claims = RM80m

The insurer should price its products appropriately to support those expected obligations.

Unexpected adverse losses

Suppose actual experience becomes:

RM110m

The additional adverse experience can be absorbed through available financial buffers, including capital, subject also to reinsurance and other financial resources.

Therefore:

Premiums should fund expected insurance costs; capital provides an important buffer against unexpected adverse outcomes.

An insurer should not deliberately underprice on the assumption:

“Don’t worry, shareholders’ capital will pay the claims.”

That would eventually destroy its capital.

10. Why Underpricing Is So Dangerous

Suppose proper premium:

RM1,000

But insurer charges:

RM700

Expected claims and expenses:

RM900

Loss expected per policy:

RM200

If it sells:

100,000 policies

Expected shortfall:

RM200 × 100,000 = RM20 million

Suppose shareholder equity starts at:

RM100 million

If similar losses repeatedly occur:

Year 1 → RM80m

Year 2 → RM60m

Year 3 → RM40m

Year 4 → RM20m

Eventually, the capital buffer can be exhausted.

That is what your earlier sentence means by:

“Underwriting losses … deplete the shareholders’ capital.”

11. Now Compare This With Takaful

This is the key reason your material is making the comparison.

Conventional Insurance

Policyholder pays premium

↓

Insurer accepts underwriting risk

↓

Claims exceed adequately available underwriting income

↓

Underwriting loss

↓

Loss is borne by the insurer

↓

Persistent losses reduce shareholders’ equity/capital

Takaful

Participants pay contributions

↓

Tabarru’ enters PRF

↓

Participants collectively share underwriting risk through PRF

↓

PRF obligations exceed relevant PRF resources

↓

Underwriting deficit

↓

PRF bears the deficit

↓

Shareholder/operator fund may provide qard, depending on the applicable arrangement

This is why the conventional insurer’s shareholders and the Takaful operator’s shareholders are in different positions regarding underwriting risk.

12. The Most Important Correction

Don’t think:

Claims exceed premiums = automatically take difference directly from shareholder capital.

Instead think:

Claims + underwriting expenses exceed relevant premium income

↓

Underwriting loss

↓

The loss reduces the insurer’s overall financial result

↓

If not offset by investment or other income:

Shareholders’ equity decreases

↓

Repeated/severe losses:

Shareholders’ capital becomes depleted

That is much more accurate.

Easy Way to Remember

Think of three layers:

PREMIUM → RESERVES/ASSETS → CAPITAL BUFFER

Premiums should be adequately priced for expected claims and expenses.

Reserves/assets support the insurer’s recognised obligations.

Capital provides an important buffer against adverse/unexpected losses.

And reinsurance can transfer part of the insurer’s risk to another insurer.

One-Sentence Summary

Yes—if a conventional insurer’s claims and underwriting expenses exceed its relevant premium income, the insurer still has to meet valid claims from its available assets; the resulting underwriting loss reduces its profits/net assets and therefore ultimately reduces shareholders’ equity or capital unless the loss is offset by investment income, reinsurance recoveries or other gains.