Takaful - How Underwriting Loss Affects Shareholders in Conventional Insurance

The key point is:

An underwriting loss does not immediately mean a “shareholder deficit.” Rather, the underwriting loss reduces the insurer’s profits/equity and, if losses continue or become sufficiently large, they can deplete shareholders’ capital.

This is easier to understand by following where the money goes.

1. Start With a Conventional Insurance Company

Suppose shareholders establish an insurance company and contribute:

Shareholders’ capital = RM100 million

The insurer then sells insurance policies.

Suppose during the year it collects:

Premiums = RM50 million

The insurer now has financial resources from both its capital base and its insurance operations.

But it also has to pay claims and expenses.

2. Suppose the Insurance Business Is Properly Priced

Assume:

Premium income = RM50m

Claims = RM35m

Underwriting expenses = RM10m

Simplified underwriting result:

RM50m − RM35m − RM10m = +RM5m

So the insurer has:

RM5 million underwriting profit

Ignoring investment income, tax and other items for simplicity, this positive result adds to the insurer’s financial position.

Very simplistically:

Starting shareholders’ equity = RM100m

+ RM5m underwriting profit

= RM105m

So profitable underwriting can strengthen shareholders’ equity.

3. Now Suppose the Insurer Underprices

Suppose the proper premium should have been higher, but the insurer deliberately charges very low premiums to attract customers.

It collects:

Premium income = RM50m

But because the business was underpriced:

Claims = RM55m

Underwriting expenses = RM10m

Therefore:

RM50m − RM55m − RM10m

= −RM15m

The insurer has:

RM15 million underwriting loss

Where does that RM15 million loss go?

In conventional insurance, there is no separate participants’ PRF that bears the underwriting result as in Takaful.

The conventional insurer itself has promised to pay the valid claims.

Therefore, the loss reduces the insurer’s net financial position.

4. The Loss Reduces Shareholders’ Equity

Suppose starting shareholders’ equity is:

RM100m

Underwriting loss:

RM15m

Ignoring all other income and expenses:

RM100m − RM15m = RM85m

So shareholders’ equity has fallen from:

RM100m → RM85m

This is what is meant when we say:

Underwriting losses can deplete shareholders’ capital.

It does not mean the shareholders personally receive an invoice for RM15 million after every bad underwriting year.

Rather, the company’s losses reduce the net assets/equity belonging to shareholders.

5. What If Underwriting Losses Continue?

Suppose the company repeatedly underprices its insurance.

Starting shareholders’ equity:

RM100m

Year 1 underwriting loss:

−RM15m

Remaining simplified equity:

RM85m

Year 2 underwriting loss:

−RM20m

Remaining:

RM65m

Year 3 underwriting loss:

−RM25m

Remaining:

RM40m

Year 4 underwriting loss:

−RM30m

Remaining:

RM10m

You can see what is happening:

Repeated underwriting losses → shareholders’ equity/capital progressively depleted

Eventually the insurer may face serious solvency problems and may need additional capital.

6. But Is This a “Shareholder Deficit”?

This is where I would correct the terminology slightly.

Don’t automatically say:

Underwriting loss = shareholder deficit

A better statement is:

Underwriting losses reduce the insurer’s profits and shareholders’ equity/capital. If losses are sufficiently large or persistent, they can deplete the shareholders’ capital and threaten solvency.

“Deficit” is especially useful in your Takaful studies when discussing the Participants’ Risk Fund (PRF):

PRF income/resources < relevant claims and obligations → PRF deficit

For conventional insurance, your study language should generally be:

Underwriting loss → reduces shareholders’ equity/capital

7. Why Must Shareholders Ultimately Bear the Conventional Insurer’s Loss?

Because conventional insurance involves risk transfer.

Suppose Ahmad pays an insurer:

RM1,000 premium

for covered property protection of:

RM100,000

The insurer has contractually accepted the relevant insurance risk.

If Ahmad later suffers a valid covered RM100,000 loss, the insurer cannot say:

“Sorry, the RM1,000 premium we charged you was too low, so you must bear our underwriting deficit.”

The insurer accepted that risk.

Therefore:

Policyholder pays premium

↓

Risk transferred to insurer

↓

Insurer pays valid covered claims

↓

If premiums prove inadequate

↓

Insurer suffers underwriting loss

↓

Loss reduces insurer/shareholder equity

That is the important chain.

8. Now Compare It With Takaful

This is why the distinction with Takaful is so important.

Conventional Insurance

Policyholders pay:

Premiums

↓

Insurer accepts underwriting risk

↓

Claims and expenses exceed premium income

↓

Underwriting loss

↓

Insurer’s profitability/equity affected

↓

Persistent losses can deplete shareholders’ capital

Takaful

Participants pay contributions.

↓

Tabarru’ goes into:

Participants’ Risk Fund (PRF)

↓

PRF collectively bears participants’ underwriting risk.

↓

PRF claims and relevant obligations exceed PRF underwriting income/resources.

↓

Underwriting deficit

↓

PRF has a deficit

↓

Depending on the applicable structure, shareholder/operator fund may provide qard or other required support.

The important structural difference is:

Conventional insurance underwriting risk is borne by the insurer, whereas in Takaful the participants collectively bear underwriting risk through the PRF.

9. This Explains the Agent-Principal Problem You Studied

Now the earlier statement should make much more sense.

Suppose a conventional insurer deliberately underprices.

Proper premium:

RM1,000

Actual premium:

RM700

More customers join.

Initially:

Turnover ↑

But later:

Claims ↑

↓

Premiums insufficient

↓

Underwriting loss

↓

Shareholders’ equity/capital ↓

So shareholders eventually suffer the financial consequences of management’s bad pricing.

In Takaful, however, suppose an operator underprices aggressively:

Lower contribution

↓

More participants

↓

Higher turnover

↓

Potentially higher Wakalah fee income

But:

Insufficient tabarru’ enters PRF

↓

Claims exceed adequate PRF resources

↓

PRF deficit

This is why the earlier discussion identified a potential conflict of interest: the operator can benefit from increased Wakalah fee volume while the underwriting deficit emerges in the participants’ risk pool.

10. One Important Accounting Point

There is one qualification to remember.

An underwriting loss does not necessarily reduce shareholders’ equity by exactly the same amount, because the insurer may also earn investment income or have other gains/losses.

For example:

Underwriting loss = −RM15m

Investment income = +RM8m

Other net income = +RM2m

Simplified overall result:

−RM15m + RM8m + RM2m = −RM5m

So although the insurer suffered a:

RM15m underwriting loss

its overall loss is only:

RM5m

Thus, it is the overall financial result that ultimately flows into shareholders’ equity.

But persistent large underwriting losses clearly put that equity/capital under pressure.

Easy Way to Remember

Conventional Insurance

Premium too low

↓

Claims + expenses > premiums

↓

Underwriting loss

↓

Insurer’s profit/net assets fall

↓

Shareholders’ equity/capital falls

↓

If repeated:

Capital depletion → Solvency problem

Takaful

Tabarru’ insufficient

↓

PRF claims/obligations > PRF underwriting income/resources

↓

Underwriting deficit

↓

PRF financial position weakens

So the simplest distinction to memorise is:

Conventional insurance: underwriting loss ultimately hits the insurer/shareholders’ financial position.

Takaful: underwriting deficit arises in the Participants’ Risk Fund because the PRF bears the underwriting risk.

Takaful - Underwriting Loss, Underwriting Deficit, Underwriting Gain and Surplus

They are closely related concepts, but the terminology depends on whether we are talking about conventional insurance or Takaful.

The easiest starting point is:

Conventional insurance → underwriting profit or underwriting loss

Takaful PRF → underwriting surplus or underwriting deficit

The underlying calculation is conceptually similar: compare the income available for underwriting against claims and relevant underwriting costs. But who bears the result is different.

1. First, What Does “Underwriting” Mean Here?

Remember that underwriting originally means assessing and accepting risks:

Should we accept this risk, and if yes, at what price and on what terms?

But when we say underwriting result, we are talking about the financial outcome of the insurance/Takaful risk business.

Very simply:

Underwriting Income − Underwriting Claims and Costs = Underwriting Result

The result can be:

Positive → gain/profit/surplus

or

Negative → loss/deficit

depending on the context and terminology.

2. What Is an Underwriting Loss in Conventional Insurance?

Suppose a conventional insurer collects:

Premiums = RM10 million

It incurs:

Claims = RM8 million

Underwriting expenses = RM3 million

Therefore:

RM10m − RM8m − RM3m = −RM1m

The underwriting result is negative.

We call this an:

Underwriting loss = RM1 million

It means the insurer’s insurance operations generated a loss because the relevant premiums were insufficient to cover claims and underwriting expenses.

3. What If the Conventional Insurer Has More Income Than Claims and Expenses?

Suppose:

Premiums = RM10 million

Claims = RM6 million

Underwriting expenses = RM2 million

Then:

RM10m − RM6m − RM2m = +RM2m

Now the underwriting result is positive.

This is generally called an:

Underwriting profit = RM2 million

You could describe it generally as an underwriting gain, but underwriting profit is the more natural conventional insurance term.

So:

Conventional Insurance

Positive underwriting result → Underwriting Profit

Negative underwriting result → Underwriting Loss

4. What Is an Underwriting Deficit in Takaful?

Now consider the Participants’ Risk Fund (PRF).

Suppose:

PRF underwriting income = RM10 million

Claims = RM8 million

Retakaful and other relevant underwriting costs/provisions = RM3 million

Then:

RM10m − RM8m − RM3m = −RM1m

The PRF has a:

RM1 million underwriting deficit

This means the PRF’s relevant underwriting income/resources for the period were insufficient relative to its underwriting obligations/costs.

5. What If the Takaful PRF Has More Income Than Its Underwriting Obligations?

Suppose:

PRF underwriting income = RM10 million

Claims = RM6 million

Retakaful and other relevant costs/provisions = RM2 million

Then:

RM10m − RM6m − RM2m = +RM2m

The PRF has an:

Underwriting surplus = RM2 million

So for Takaful:

Positive underwriting result → Underwriting Surplus

Negative underwriting result → Underwriting Deficit

6. So Is “Loss” the Same as “Deficit”?

Mathematically, they can describe a similar negative underwriting outcome.

But the terminology reflects the structure.

In conventional insurance:

Premiums insufficient relative to claims/underwriting expenses → Underwriting loss

In Takaful PRF:

PRF underwriting income insufficient relative to claims/relevant obligations → Underwriting deficit

Therefore, I would recommend that you keep the terminology separate when studying:

Conventional Insurance

Profit ↔ Loss

Takaful PRF

Surplus ↔ Deficit

That will make the distinction much easier.

7. Why Don’t We Normally Call a Takaful PRF Deficit a “Shareholder Underwriting Loss”?

Because the PRF is separate from the shareholders’ fund.

Remember:

Participants contribute tabarru’ → PRF

and:

PRF bears the participants’ underwriting risk

The Takaful operator manages the arrangement.

Therefore, if the PRF has:

RM10m income

but:

RM12m relevant underwriting obligations

then:

RM10m − RM12m = −RM2m

We say:

The PRF has an RM2 million underwriting deficit.

We should not automatically say:

“The shareholders made an RM2 million underwriting loss.”

Those are not necessarily the same thing.

8. This Explains the Previous Statement

You previously asked about:

“In conventional insurance deliberately underpricing while temporarily increasing turnover will eventually result in underwriting losses and deplete shareholders’ capital.”

Now you can see exactly what it means.

Suppose a conventional insurer underprices:

Premiums = RM10m

Claims + underwriting expenses = RM13m

Therefore:

RM10m − RM13m = −RM3m

Underwriting loss = RM3m

Because the conventional insurer bears the underwriting risk, persistent losses can eventually reduce shareholders’ financial resources/capital.

9. Now Compare the Same Situation in Takaful

Suppose poor pricing means the PRF receives:

RM10m

But claims and relevant PRF costs/provisions are:

RM13m

Therefore:

RM10m − RM13m = −RM3m

Underwriting deficit = RM3m

So:

Conventional insurance → RM3m underwriting loss

Takaful PRF → RM3m underwriting deficit

This is exactly the distinction being made in your material.

10. What About the Word “Gain”?

“Gain” is a general financial word meaning a positive financial outcome.

But for your study purposes, I would use the more precise terminology.

Conventional Insurance

If:

Premiums > Claims + Underwriting Expenses

→ Underwriting Profit

Takaful PRF

If:

PRF Underwriting Income > Claims + Relevant PRF Costs/Provisions

→ Underwriting Surplus

So rather than writing “underwriting gain”, use:

underwriting profit for conventional insurance

and

underwriting surplus for the Takaful PRF.

11. What About “Exceeds”?

Exceeds is not the name of the result.

“Exceeds” simply means:

is greater than

For example:

“Premium income exceeds claims and underwriting expenses.”

Suppose:

Premiums = RM10m

Claims + expenses = RM8m

Then:

RM10m exceeds RM8m by RM2m.

The RM2m positive underwriting result may be called:

underwriting profit in conventional insurance.

Similarly:

“PRF underwriting income exceeds relevant claims and costs by RM2m.”

Then the PRF may have:

RM2m underwriting surplus.

So:

“Exceeds” describes the comparison.

“Profit/surplus” describes the positive result.

12. What About the Word “Excess”?

Be careful here because excess can mean something completely different in insurance.

For example, in Excess of Loss Retakaful:

RM1m retention + Retakaful covers losses above RM1m

Here, “excess” means the part of a loss above a specified level.

So don’t use excess as a substitute for underwriting surplus unless the particular context clearly uses it that way.

For your notes, use:

Surplus, not “excess,” for a positive PRF underwriting result.

13. One Complete Conventional Insurance Example

Suppose a conventional insurer has:

Premium income = RM20m

Claims = RM14m

Underwriting expenses = RM4m

Therefore:

RM20m − RM14m − RM4m = +RM2m

Underwriting profit = RM2m

Now suppose the following year:

Premium income = RM20m

Claims = RM19m

Expenses = RM4m

Therefore:

RM20m − RM19m − RM4m = −RM3m

Underwriting loss = RM3m

So:

Positive = Profit

Negative = Loss

14. One Complete Takaful Example

Now suppose a PRF has:

Relevant underwriting income = RM20m

Claims = RM14m

Retakaful/relevant costs and provisions = RM4m

Therefore:

RM20m − RM14m − RM4m = +RM2m

Underwriting surplus = RM2m

Next year:

PRF underwriting income = RM20m

Claims = RM19m

Relevant costs/provisions = RM4m

Therefore:

RM20m − RM19m − RM4m = −RM3m

Underwriting deficit = RM3m

So:

Positive = Surplus

Negative = Deficit

15. Why “Surplus” Is Particularly Important in Takaful

The word surplus reflects the mutual nature of the PRF.

The PRF belongs to the participants collectively according to the applicable Takaful structure; the operator manages it.

Therefore, if the PRF performs favourably, the positive underwriting result is not automatically treated as ordinary shareholder profit.

It is an underwriting surplus of the PRF.

Its treatment may include, depending on the model, certificate terms and applicable rules:

retention in the PRF,

distribution to eligible participants,

or another approved surplus-sharing arrangement.

16. And Why “Deficit” Is Particularly Important

Similarly, when the PRF has insufficient resources relative to its relevant obligations, we call it a deficit.

For example:

PRF income/resources = RM10m

Relevant claims/costs = RM12m

Therefore:

Deficit = RM2m

Depending on the applicable Takaful model and regulatory framework, the operator/shareholder fund may provide qard to support the PRF.

Remember:

Qard = interest-free loan

It is different from treating the PRF deficit automatically as an underwriting loss belonging to shareholders.

17. But There Is One Important Exception From What You Just Studied

You recently studied the situation where a PRF deficit is caused by the operator’s own failure to discharge its responsibilities properly.

For example:

deliberate improper pricing

↓

excessive sales

↓

insufficient tabarru’

↓

PRF deficit

The approach in your material argues that such a deficit should be funded through an outright shareholder transfer rather than qard, because participants should not ultimately bear the consequences of the operator’s improper conduct.

That is different from a genuine PRF deficit caused by unexpectedly adverse claims despite prudent management.

18. Don’t Confuse Underwriting Result With Overall Profit

This is another very important point.

An underwriting loss does not necessarily mean the conventional insurance company has an overall net loss.

Suppose:

Underwriting result = −RM2m

Investment income = +RM5m

Other items = −RM1m

Simplified overall result:

−RM2m + RM5m − RM1m = +RM2m

So the insurer had:

Underwriting loss = RM2m

but still had:

Overall positive result = RM2m

Therefore:

Underwriting result refers specifically to the result from the underwriting/insurance operation, not necessarily the entire company’s final profit or loss.

The same care is needed when distinguishing a Takaful PRF’s underwriting surplus/deficit from investment results and the operator/shareholder company’s own profit.

Easy Way to Remember

Use this:

Conventional Insurance

Positive → PROFIT

Negative → LOSS

Takaful PRF

Positive → SURPLUS

Negative → DEFICIT

And:

Exceeds = simply means “greater than.”

Simple Formula

Conventional Insurance

Premium Income − Claims − Underwriting Expenses = Underwriting Result

If positive:

Underwriting Profit

If negative:

Underwriting Loss

Takaful PRF

In simplified form:

PRF Underwriting Income − Claims − Retakaful Costs − Relevant Expenses/Provisions = PRF Underwriting Result

If positive:

Underwriting Surplus

If negative:

Underwriting Deficit

The Four Words to Memorise

Conventional Insurance:

PROFIT ↔ LOSS

Takaful PRF:

SURPLUS ↔ DEFICIT

So when you read:

“Conventional insurance underpricing results in underwriting losses.”

think:

Insurer’s underwriting income < claims and underwriting expenses → LOSS

When you read:

“Poor Takaful pricing results in a deficit in the risk pool.”

think:

PRF underwriting income/resources < relevant claims and costs → DEFICIT

The mathematics can be similar, but the structure, ownership of the funds, and who ultimately bears the underwriting result are different.

Takaful - Understanding Underpricing, Underwriting Loss and Shareholders’ Capital

The sentence means:

If a conventional insurer deliberately charges premiums that are too low in order to attract more customers and increase sales, it may initially appear successful. However, when claims eventually arise, the inadequate premiums may cause underwriting losses, which ultimately reduce the shareholders’ capital.

1. What Does “Deliberately Underpricing” Mean?

Underpricing means charging a premium that is lower than the amount actuarially required to support the risk and associated costs.

For example, suppose actuarial calculations indicate that the appropriate premium should be:

RM1,000 per policy

This RM1,000 is needed to support expected claims, expenses and an appropriate allowance for uncertainty.

However, the insurer deliberately charges only:

RM700

Why?

Because cheaper insurance may attract more customers.

So:

Proper price = RM1,000

Actual price charged = RM700

Underpricing = RM300

2. Why Would an Insurer Deliberately Underprice?

The insurer might want to increase its turnover, meaning its volume of business or premium income.

Suppose:

Before reducing the price

Premium = RM1,000

Customers = 10,000

Premium turnover:

RM1,000 × 10,000 = RM10 million

Now the insurer reduces the price to:

RM700

Because it is much cheaper, it attracts:

20,000 customers

Premium turnover becomes:

RM700 × 20,000 = RM14 million

So premium turnover has increased:

RM10m → RM14m

At first, this looks impressive.

Customers ↑

Policies sold ↑

Premium turnover ↑

Management might say:

“Our business is growing rapidly.”

But there is a hidden problem.

3. The Risks Have Not Become Cheaper Just Because the Premium Was Reduced

Suppose the expected claims cost is:

RM800 per policy

With 20,000 customers:

Expected claims = RM800 × 20,000

= RM16 million

But the insurer collected only:

RM14 million premiums

Even before considering other relevant expenses:

Premium income = RM14m

Expected claims = RM16m

Therefore:

RM14m − RM16m = −RM2m

The insurer has an expected RM2 million underwriting shortfall in this simplified example.

So increasing sales does not help if every new policy is inadequately priced.

4. More Sales Can Actually Make the Problem Bigger

This is a very important concept.

Imagine the insurer loses approximately:

RM100 on every policy

If it sells:

1,000 policies

Potential loss:

RM100,000

If it sells:

100,000 policies

Potential loss:

RM10 million

Therefore:

Selling more underpriced policies can increase losses rather than solve them.

This is why:

Higher turnover ≠ Higher profitability

if the underlying business is badly priced.

5. What Is an Underwriting Loss?

An underwriting loss occurs when the relevant premiums are insufficient to cover claims and underwriting-related expenses for the period.

A simplified formula is:

Underwriting Result = Premium Income − Claims − Underwriting Expenses

Suppose:

Premium income = RM100 million

Claims = RM90 million

Underwriting expenses = RM20 million

Then:

RM100m − RM90m − RM20m = −RM10m

The insurer has:

RM10 million underwriting loss

6. Why Does This Eventually Affect Shareholders’ Capital?

In conventional insurance, the insurer itself bears the underwriting risk.

The premiums belong to the insurance business, and the insurer is contractually responsible for paying covered claims.

Suppose:

Insurer’s assets/resources from operations are insufficient by:

RM20 million

The insurer cannot simply tell policyholders:

“Our premiums were too low, so we will not pay your valid claims.”

The insurer remains responsible for its contractual obligations.

Therefore, persistent underwriting losses ultimately reduce the insurer’s financial resources and can erode the capital attributable to shareholders.

7. Simple Example of Capital Being Depleted

Suppose a conventional insurer starts with:

Shareholders’ capital = RM100 million

Year 1

Underwriting loss = RM10m

Simplified remaining capital:

RM90m

Year 2

Underwriting loss = RM20m

Remaining:

RM70m

Year 3

Underwriting loss = RM30m

Remaining:

RM40m

If losses continue, the financial buffer becomes progressively weaker.

This is what is meant by:

“Underwriting losses deplete shareholders’ capital.”

The actual accounting and solvency calculation is more complex, but this illustrates the economic idea.

8. Why Is the Word “Eventually” Important?

Underpricing may not look dangerous immediately.

Imagine the insurer launches a very cheap product in January.

Thousands of customers purchase it.

Immediately, the insurer receives:

large amounts of premium cash

Management sees:

Sales ↑

Customer numbers ↑

Premium turnover ↑

But many claims may occur only later.

Therefore, initially:

Money comes in first

while:

many claims come later

This can create the appearance of success.

Eventually, when the claims develop, the insurer discovers that the premiums were insufficient.

So:

Today → High sales look successful

Later → Claims emerge

Later still → Underwriting losses become clear

That is why deliberately underpricing can create temporary growth but long-term financial weakness.

9. This Is Very Important for Your Takaful Topic

Now compare this with Takaful.

Conventional Insurance

Insurer deliberately underprices.

↓

More customers buy insurance.

↓

Turnover temporarily increases.

↓

Premiums are insufficient for the risks accepted.

↓

Claims emerge.

↓

Underwriting losses occur.

↓

Insurer/shareholders ultimately suffer financially and capital can be depleted.

Takaful

Suppose the Takaful operator underprices to attract more participants.

↓

More participants join.

↓

Contribution turnover increases.

↓

Wakalah fee income may increase.

↓

But after deducting the Wakalah fee, insufficient tabarru’ may enter the PRF.

↓

Claims emerge.

↓

PRF experiences deficit.

This is the conflict you were studying earlier.

10. Why This Creates a Special Agency Concern in Takaful

In conventional insurance, shareholders have a direct financial reason to stop persistent underpricing because:

Poor pricing → Underwriting loss → Shareholder capital affected

But under a Wakalah Takaful structure:

Operator receives Wakalah fee

while:

PRF bears underwriting risk

Therefore, if the incentive structure is poorly designed:

Operator may benefit from higher turnover

while:

Participants’ Risk Fund suffers the consequences of inadequate pricing.

That is why Takaful governance needs to align:

Operator interests

with

Participant/PRF interests.

Very Simple Example

Imagine two businesses selling something that costs them:

RM100

Business A

Selling price:

RM120

Profit per item:

RM20

It sells 1,000 items.

The business is sustainable.

Business B

Selling price:

RM80

Loss per item:

RM20

Because it is so cheap, it sells 10,000 items.

Management proudly says:

“We sold ten times more!”

But:

RM20 loss × 10,000 = RM200,000 loss

So the increase in turnover actually magnified the problem.

The same basic logic applies to insurance underpricing.

Easy Way to Remember

Think:

CHEAP → MORE SALES → MORE CLAIMS → LOSSES → CAPITAL ↓

More precisely:

Underpricing

↓

More customers

↓

Higher temporary turnover

↓

Premiums insufficient for risks

↓

Claims eventually emerge

↓

Underwriting losses

↓

Shareholders’ capital depleted

Simple Formula

Underwriting Result = Premium Income − Claims − Underwriting Expenses

If:

Premium Income < Claims + Underwriting Expenses

then:

Underwriting Loss

If significant underwriting losses continue:

Repeated Underwriting Losses → Reduced Financial Resources → Depletion of Shareholders’ Capital

One-Sentence Summary

In conventional insurance, deliberately charging premiums below an actuarially adequate level may temporarily attract more customers and increase turnover, but when claims eventually emerge, the inadequate premiums can produce underwriting losses that reduce the insurer’s financial resources and ultimately deplete shareholders’ capital.

Takaful - Alignment of the Interests of All Stakeholders

Alignment of interests means designing the governance, incentives and reward systems of an organisation so that the important stakeholders are encouraged to work toward the same long-term objective, rather than one stakeholder benefiting by harming another.

The basic idea is:

A financial institution is more sustainable when shareholders, management and customers benefit from its long-term success rather than being rewarded for actions that produce short-term gains but create long-term losses.

This concept is particularly important in Takaful because there are several stakeholders whose interests need to be balanced.

1. What Does “Alignment of Interests” Mean?

Imagine three parties:

Shareholders want a reasonable return on their investment.

Management wants salaries, bonuses and career advancement.

Customers/policyholders want reliable protection, fair pricing and claims to be paid.

These interests are not automatically identical.

For example, management might increase sales rapidly to obtain a large bonus.

But if those sales are achieved through underpricing, the business could suffer large losses later.

Management may benefit today, while shareholders and customers suffer tomorrow.

Therefore, good governance tries to ensure:

What benefits management should also support the long-term interests of shareholders and customers.

That is alignment of interests.

2. Stakeholders in a Proprietary Insurer

A proprietary insurer is essentially a shareholder-owned insurance company.

The main stakeholders include:

Shareholders

Management

and

Policyholders

Policyholders become particularly relevant to profit alignment where they participate in profits, such as under certain with-profit life insurance policies.

Each stakeholder has a different role and interest.

3. Shareholders

Shareholders provide capital and own the proprietary insurance company.

Their interest normally includes:

profitability

sustainable growth

dividends

and

increasing the long-term value of the company

Suppose shareholders invest:

RM100 million

Naturally, they expect the company to generate an appropriate return.

But they should generally prefer sustainable profits, rather than high profits for one year followed by severe losses.

4. Management

Management runs the company on behalf of shareholders.

Management makes important decisions concerning:

pricing

underwriting

investments

claims

distribution

risk management

and

business growth

However, management does not necessarily own all the capital it is managing.

This creates another principal-agent relationship.

Shareholders = Principal

Management = Agent

Shareholders therefore need mechanisms to ensure management acts in their interests.

5. How Do Shareholders Control Management?

One important mechanism is the board of directors.

The simplified relationship is:

Shareholders

↓

Board of Directors

↓

Management

↓

Business Operations

The board oversees management and helps ensure that management operates the company appropriately.

Therefore, corporate governance is one mechanism for aligning:

Management interests ↔ Shareholder interests

6. Compensation Can Also Align Management With Shareholders

Suppose a manager receives only:

RM20,000 monthly salary

regardless of the company’s performance.

The manager may have relatively little direct financial incentive to improve the company’s performance.

A company might therefore introduce performance-related compensation.

For example:

Base salary = RM20,000 per month

plus

Bonus linked to appropriate company performance.

Now management has an additional incentive to help the company succeed.

In principle:

Company performs well → Shareholders benefit → Management also benefits

This is an example of alignment through compensation.

7. But Compensation Must Be Designed Carefully

This is where the problem becomes more interesting.

Suppose management receives a huge bonus whenever:

annual sales increase

or

current-year profit increases.

Management may then focus heavily on:

“How can I maximise this year’s sales and profit?”

rather than:

“How can I keep this company financially strong for the next 20 years?”

That can create short-termism.

8. Example - Sales-Based Bonus Creates the Wrong Incentive

Suppose management receives:

RM1 million bonus

if annual sales exceed:

RM500 million

Current sales are only:

RM400 million

Management wants the bonus.

One way to increase sales quickly might be to reduce prices substantially.

Suppose the actuarially appropriate premium is:

RM1,000

Management reduces it to:

RM750

Customers find the product attractive.

Sales increase dramatically.

Management reaches:

RM550 million sales

and receives the bonus.

At first:

Sales ↑

Turnover ↑

Management bonus ↑

Everything appears successful.

But there is a hidden problem.

9. The Business May Have Been Underpriced

Suppose the insurer needed approximately:

RM1,000

per policy to support the underlying risk and expenses.

But it charged:

RM750

Shortfall:

RM250 per policy

Initially, the company may report impressive growth.

But as claims emerge:

Claims > Adequate Premium Income

↓

Underwriting Losses

↓

Capital is depleted

↓

Solvency pressure increases

So management’s incentive created:

Short-Term Gain

but potentially:

Long-Term Financial Damage

This is an example of poor alignment.

10. Growth Is Not Automatically Good

This is an extremely important principle.

Suppose:

Insurer A

Sales growth = 5%

but it has:

proper pricing

good underwriting

good claims management

and

sustainable profitability

Insurer B

Sales growth = 40%

but achieves this through:

underpricing

poor underwriting

and

accepting excessive risks

Insurer B appears more successful if we look only at:

sales growth

But rapid growth may actually be creating future losses.

Therefore:

More sales do not automatically mean a healthier insurance business.

11. Improper Underwriting Can Create the Same Problem

Management may also increase sales by relaxing underwriting standards.

Suppose an insurer normally rejects extremely high-risk applicants.

Management wants rapid growth and tells underwriters:

“Accept more business. We need to increase sales.”

The company begins accepting risks that should have been:

rejected

charged higher premiums

or

accepted subject to special conditions

Sales increase.

Management’s performance targets are achieved.

But the insurer now has a portfolio containing excessive risks.

Later:

Claims increase → Underwriting losses increase → Capital decreases

Again:

Management gains today → Company suffers tomorrow

12. Risky Investments Can Also Produce Misalignment

Management might also try to increase short-term investment returns.

Suppose there are two investment strategies.

Strategy A

Expected return:

5%

Relatively lower risk.

Strategy B

Possible return:

15%

but with substantially greater risk of major losses.

If management’s annual bonus depends heavily on current-year investment returns, managers may have an incentive to choose Strategy B.

If the investment succeeds:

Company profit ↑

Management bonus ↑

But if the investment subsequently collapses:

Company assets ↓

Capital ↓

Solvency risk ↑

Therefore, poorly designed compensation can encourage excessive risk-taking.

13. Alignment Between Shareholders and Policyholders

Shareholders and policyholders can also have different interests.

Shareholders generally want:

higher profits

while policyholders want:

reasonable prices

strong financial security

good benefits

and

reliable claims payment

One mechanism that can create some alignment is profit or surplus participation in appropriate products.

For example, certain traditional with-profit life insurance policies allow policyholders to participate in part of the financial performance of the relevant business.

This can create some shared interest between:

Shareholders

and

Participating Policyholders

because both may benefit when the business performs sustainably.

14. Example of Surplus Sharing

Suppose a participating insurance fund generates an appropriate distributable surplus of:

RM10 million

Under the applicable arrangement, some benefit may be allocated to participating policyholders while shareholders receive their applicable share.

Now both groups have some interest in the sustainable performance of the business.

Conceptually:

Good Long-Term Performance

↓

Shareholders benefit

• ●

Participating policyholders benefit

This can help align interests.

But the precise allocation depends on the particular insurance arrangement.

15. Alignment Can Still Become Destructive

This is the crucial warning.

Simply linking everyone’s rewards to company performance does not automatically produce good alignment.

The question is:

What type of performance are they being rewarded for?

Suppose management’s bonus is based only on:

sales volume

Management may maximise sales.

If based only on:

one-year profits

management may maximise short-term profit.

If based only on:

investment return

management may take excessive investment risks.

Therefore:

Bad Performance Measure → Bad Incentive → Bad Behaviour

even though the original intention was to “align interests.”

16. Short-Term Profit vs Long-Term Financial Stability

Consider this example.

An insurer has:

RM200 million shareholder capital

Management can choose between two strategies.

Strategy A - Prudent

Expected annual profit:

RM20 million

with relatively controlled risk.

Strategy B - Aggressive

Potential annual profit:

RM50 million

but with the possibility of a very large future loss.

If management receives a large bonus based only on this year’s profit, it may prefer Strategy B.

If Strategy B generates RM50 million this year:

Management receives large bonus

Shareholders initially see high profit

But next year the risky positions may generate:

RM150 million loss

Now:

capital is severely damaged

So the initial alignment was actually badly designed.

17. Good Alignment Should Reward Sustainable Performance

A better incentive system considers not merely:

How much did you sell?

but also:

Was it properly priced?

Was underwriting prudent?

Did the business remain profitable after claims emerged?

Were risks properly managed?

Was capital protected?

Were customers treated appropriately?

Is the business sustainable over the long term?

This creates a more balanced incentive.

18. Example - Better Management Compensation

Instead of giving management a bonus solely for:

30% sales growth

the company could evaluate several factors, such as:

sustainable profitability

underwriting quality

risk management

capital strength

customer outcomes

and

long-term performance

The principle is:

Do not reward management simply for producing more business; reward management for producing good-quality, sustainable business.

19. Connection With Your Previous Topic - Agent-Principal Conflict

This is very closely related to the agent-principal problem you just studied.

Previously:

Participants = Principal

Takaful Operator = Agent

Potential problem:

More contribution turnover → More Wakalah fees for operator

even if poor pricing creates:

PRF deficit

Now we have another agency relationship:

Shareholders = Principal

Management = Agent

Potential problem:

More short-term sales/profits → Higher management remuneration

even if excessive risk-taking creates:

long-term financial losses

The underlying issue is the same:

The agent may maximise what benefits the agent rather than what protects the principal.

20. Why This Is Especially Important for Takaful

Takaful has an even broader stakeholder structure because we need to consider:

Participants

Participants’ Risk Fund

Takaful operator

Management

Shareholders

intermediaries

Retakaful providers

and

regulators

These stakeholders can have different objectives.

For example:

Participants want affordable and reliable protection.

Operator wants sustainable Wakalah fee income and profitability.

Shareholders want a reasonable return.

Management wants remuneration and career rewards.

Intermediaries may want commissions.

Regulators want solvency, fair treatment and financial stability.

Therefore, Takaful governance should try to prevent one stakeholder from obtaining benefits by transferring excessive risk or cost to another stakeholder.

21. Takaful Example of Good Alignment

Suppose a Takaful operator wants to increase Motor Takaful sales.

A poorly aligned system might reward management simply for:

number of certificates sold

Management could then:

reduce contributions excessively

relax underwriting

and

accept poor risks

Sales increase.

Wakalah fees increase.

Management bonuses increase.

But:

PRF deficits also increase.

A better aligned system would consider:

sales growth

together with:

adequacy of tabarru’

underwriting quality

claims experience

PRF financial strength

participant outcomes

and

long-term sustainability

Now management cannot simply maximise sales while ignoring the consequences to the PRF.

22. Connection With Pricing and Margin

This also connects everything you have recently studied.

Suppose actuarial analysis determines:

Expected claims = RM700

Appropriate margin = RM100

Therefore, the PRF needs approximately:

RM800

Suppose:

Total contribution = RM1,000

Wakalah fee = RM200

Tabarru’ = RM800

The arrangement is appropriately funded under our simplified assumptions.

But management wants rapid growth and reduces the total contribution to:

RM800

while the Wakalah structure results in only:

RM640

entering the PRF.

Yet the PRF still requires approximately:

RM800

Now:

Sales may increase

Wakalah fee volume may increase

but

PRF adequacy deteriorates

This is precisely why pricing, margins, Wakalah fees and incentive alignment are interconnected.

23. The Core Problem Is Not Profit

It is important not to misunderstand the concept.

The problem is not that shareholders, management or operators should not earn money.

A sustainable commercial Takaful operation needs:

capital providers

competent management

employees

technology

distribution

and other resources.

These stakeholders need appropriate compensation.

The problem arises when:

One stakeholder can increase its own reward by taking actions that impose excessive risks or losses on another stakeholder.

That is what good governance should prevent.

Easy Way to Remember

Think:

SAME DIRECTION

Good alignment means:

Shareholders

Management

Participants

Operator

should all have incentives pointing toward:

Long-Term Sustainable Takaful

Not:

Management → short-term bonus

while

Shareholders → long-term losses

and

Participants → weak PRF

Everyone’s incentives should encourage sustainable performance.

Simple Formula

Poor Alignment

Short-Term Sales/Profit Target → Excessive Risk-Taking / Underpricing / Poor Underwriting → Immediate Management Reward → Future Financial Loss

Better Alignment

Appropriate Incentives + Prudent Underwriting + Proper Pricing + Risk Management + Long-Term Performance Measures = Better Stakeholder Alignment

Connection With All Your Recent Concepts

You can now connect the whole chain:

Management wants higher remuneration

↓

May seek higher sales

↓

Lower prices can attract more participants

↓

But lower prices can produce inadequate contributions

↓

After Wakalah fee, tabarru’ may become insufficient

↓

PRF may not contain an adequate margin for uncertainty

↓

Claims may exceed available resources

↓

Surplus decreases or deficit arises

↓

PRF may require qard

↓

Financial strength and solvency come under pressure

This is why:

Pricing, underwriting, Wakalah fees, margins, surplus, solvency and stakeholder alignment are all connected parts of Takaful risk management.

One-Sentence Summary

Alignment of stakeholder interests means designing governance and incentives so that shareholders, management, operators and participants benefit from the long-term financial strength of the business; if management is rewarded mainly for immediate sales or profits, it may be encouraged to underprice products, weaken underwriting or take excessive investment risks, producing short-term rewards but threatening long-term solvency and participant interests.

Takaful - Conflict in an Agent-Principal Arrangement

This issue is about a possible conflict of interest between the Takaful operator and the participants under a Wakalah arrangement.

The basic relationship is:

Participants = Principal

Takaful Operator = Agent (Wakil)

The participants appoint the operator to manage the Takaful arrangement on their behalf. The operator receives a Wakalah fee for providing this service.

The potential problem arises when the way the Wakalah fee is calculated gives the operator an incentive to increase contribution volume, even when doing so may weaken the Participants’ Risk Fund (PRF).

1. What Is an Agent-Principal Relationship?

An agent-principal relationship exists when one party appoints another party to act on its behalf.

In Takaful:

Participants appoint the Takaful operator to manage the Takaful operation on their behalf.

Therefore:

Principal = Participants

Agent/Wakil = Takaful Operator

For example, participants are not personally going to:

underwrite every participant,

manage claims,

arrange Retakaful,

manage the PRF,

keep financial records,

and administer certificates.

Instead, they appoint the Takaful operator to perform these activities.

2. How Does the Operator Earn Money?

Under a Wakalah model, the operator receives a Wakalah fee.

Suppose participants collectively pay:

RM100 million contributions

and the Wakalah fee is:

20% of contributions

The operator receives:

RM100m × 20% = RM20 million Wakalah fee

If contributions increase to:

RM150 million

then:

RM150m × 20% = RM30 million Wakalah fee

Therefore:

Higher contribution volume → Higher absolute Wakalah fee

This creates an economic incentive for the operator to increase business volume.

3. What Does “Turnover” Mean Here?

Here, turnover basically refers to the volume of Takaful business/contributions generated.

For example:

Year 1 contributions:

RM100 million

Year 2 contributions:

RM150 million

Turnover has increased substantially.

Increasing turnover is not automatically bad.

If the operator attracts more participants through:

good products

good service

proper pricing

careful underwriting

and

effective distribution

then business growth can be healthy.

The problem arises when the operator increases turnover through underpricing or poor underwriting.

4. Where Does the Conflict of Interest Arise?

Suppose the Wakalah fee is:

20% of total contributions

The operator benefits financially when it sells more Takaful certificates.

This could create an incentive to think:

“If we reduce contributions, more people may join. If more people join, total contribution volume may increase. If contribution volume increases, our Wakalah fee increases.”

But lower prices can become dangerous if they are actuarially inadequate.

So the operator’s interest may become:

Increase sales → Increase contributions collected → Increase Wakalah fee

while the participants’ interest is:

Proper pricing → Adequate PRF → Sufficient money for claims → Financially sustainable risk pool

These interests are not necessarily automatically aligned.

5. Example - Properly Priced Product

Suppose the actuarially appropriate contribution is:

RM1,000 per participant

The Wakalah fee is:

20%

Therefore:

RM200 → Operator

RM800 → PRF as tabarru’

Suppose the RM800 allocation is actuarially adequate for the expected PRF obligations.

If:

10,000 participants join

total contributions are:

RM10 million

Operator Wakalah fees:

RM2 million

Tabarru’ into PRF:

RM8 million

If the risks were properly underwritten and priced, this may represent healthy growth.

6. Now Suppose the Operator Reduces the Price

Imagine the operator wants to attract many more participants.

Instead of charging:

RM1,000

it charges:

RM800

Because the price is cheaper, suppose:

20,000 participants join

Total contributions become:

20,000 × RM800 = RM16 million

The Wakalah fee remains 20%.

Therefore:

Operator Wakalah fee = RM3.2 million

The operator’s Wakalah fee has increased from:

RM2 million → RM3.2 million

So the operator benefits from the higher turnover.

But now look at the PRF.

7. The PRF May Become Underfunded

From each RM800 contribution:

20% Wakalah fee = RM160

Remaining tabarru’:

RM640

Suppose actuarial analysis indicates that approximately:

RM800 per participant

should actually have been allocated to the PRF to support the risk adequately.

But only:

RM640

is entering the PRF.

So:

Required = RM800

Actual = RM640

Shortfall = RM160 per participant

Across 20,000 participants:

RM160 × 20,000 = RM3.2 million potential funding shortfall

The operator has increased its Wakalah fee income through higher turnover, while the PRF may have become financially weaker.

That is the central conflict.

8. Poor Underwriting Can Create the Same Problem

The operator does not necessarily have to reduce prices to create this problem.

It could also accept too many high-risk participants without charging contributions appropriate to their risks.

Suppose a participant represents an expected risk cost of:

RM1,500

but is accepted at a contribution appropriate for someone whose risk cost is only:

RM800

This attracts more business but exposes the PRF to claims that are not adequately funded.

Therefore:

Poor Underwriting + Inadequate Pricing → More Business Today → Potential PRF Deficits Later

9. Why Is This an Agent-Principal Conflict?

Because the benefit and the cost can fall on different parties.

Operator

Benefits from:

higher Wakalah fee income

Participants / PRF

May suffer:

inadequate tabarru’

higher claims relative to contributions

lower surplus

or

PRF deficit

Therefore:

Operator receives more fee

while:

Participants’ risk fund bears the consequences of poor underwriting

This creates an agency problem.

10. Very Simple Example

Imagine Ahmad appoints Ali to manage a fund.

Ahmad tells Ali:

“I will pay you 20% of every RM1 you bring into the fund.”

Ali therefore has an incentive to bring as much money and business into the arrangement as possible.

But suppose Ali begins accepting very risky business simply because doing so increases the amount on which his 20% fee is calculated.

Ali receives:

more fees

while Ahmad’s fund bears:

more losses

That is a conflict between:

Agent’s financial incentive

and

Principal’s financial interest.

11. Why Is the Issue Different in Conventional Insurance?

The economic consequence is different because, in conventional insurance, the insurer generally bears the underwriting risk.

Suppose a conventional insurer deliberately underprices its products.

Proper premium should be:

RM1,000

but it charges:

RM700

It attracts many customers.

Initially:

Sales ↑

Premium volume ↑

But eventually:

Claims > adequate premiums

↓

Underwriting losses

↓

Shareholders’ financial resources are affected

Therefore, the conventional insurer and its shareholders have a strong direct financial reason not to underprice indefinitely.

12. Why Can the Conflict Be More Complicated in Takaful?

In Takaful:

PRF bears the participants’ underwriting risk

while:

Operator receives Wakalah fee for managing the arrangement.

Therefore, suppose the operator underprices aggressively.

It may initially experience:

More participants

↓

Higher contribution volume

↓

Higher Wakalah fee

But the consequences of inadequate underwriting may appear in:

PRF claims

↓

PRF underwriting deficit

The financial benefit and underwriting consequence may therefore fall into different funds.

This is the important structural issue.

13. Compare the Two Very Carefully

Conventional Insurance

Insurer underprices.

↓

More customers.

↓

Premium volume increases.

↓

Claims eventually exceed adequate premiums.

↓

Insurer/shareholder financial position suffers.

Takaful Under a Wakalah Structure

Operator underprices or accepts poor risks.

↓

More participants.

↓

Contribution volume increases.

↓

Operator’s Wakalah fee may increase.

↓

Insufficient tabarru’ may enter PRF relative to risk.

↓

Claims become excessive relative to PRF resources.

↓

PRF suffers deficit.

This is why simply saying:

“The operator is only an agent.”

does not solve the incentive problem.

14. Connection With Your Previous Topic - Wakalah Fee

This directly connects with the issue you studied earlier.

Suppose:

Total contribution = RM1,000

Wakalah fee = RM200

Tabarru’ = RM800

If RM800 is actuarially adequate, there may be no problem.

But suppose the operator reduces the total contribution to:

RM750

Wakalah fee at 20%:

RM150

Tabarru’:

RM600

Yet the PRF really needs:

RM800

Now:

RM600 < RM800

The participant sees a cheaper Takaful product.

The operator may gain more sales.

But the PRF becomes inadequately funded.

15. Connection With Surplus

Poor pricing also affects the possibility of generating a surplus.

Suppose:

PRF tabarru’ = RM10 million

Claims and relevant obligations = RM8 million

Simplified surplus:

RM2 million

Now suppose underpricing results in only:

RM7 million

entering the PRF.

But claims and obligations remain:

RM8 million

Then:

RM7m − RM8m = −RM1m

Instead of:

RM2m surplus

the PRF has:

RM1m deficit

So poor pricing can transform a potentially sustainable risk pool into a deficit situation.

16. What Is Fiduciary Responsibility?

This is another very important concept.

A fiduciary responsibility means the operator is entrusted to act responsibly, honestly and carefully in managing the interests and assets placed under its management.

In simple terms:

The operator should not exploit its position as agent to benefit itself at the unfair expense of participants.

Under Wakalah, the operator is not simply:

“Someone who collects a fee.”

It is a Wakil entrusted with managing the participants’ arrangement.

Therefore, the operator should exercise appropriate care in matters such as:

pricing

underwriting

claims management

investment

Retakaful

PRF management

and

conflicts of interest.

17. Fiduciary Character of Wakalah

The idea of Wakalah should therefore not be reduced to:

Participants pay fee → Operator performs service

There is also an element of trust and responsibility.

The operator is entrusted with managing funds and risks on behalf of participants.

Therefore:

Wakalah = Agency + Fee + Trust/Responsibility

The operator should not deliberately pursue a strategy that increases its fee while knowingly damaging the financial position of the participants’ risk fund.

18. Mudarabah Has a Similar Responsibility

Under Mudarabah:

Participants/capital providers provide the relevant funds

while:

Mudarib manages/invests them

according to the applicable arrangement.

The Mudarib is also expected to perform its role responsibly.

Therefore, whether acting as:

Wakil under Wakalah

or

Mudarib under Mudarabah

the operator’s role involves responsibilities toward the funds and participants it serves.

19. Normal PRF Deficit vs Deficit Caused by Operator Misconduct

This is a particularly important distinction.

Not every PRF deficit means the operator did something wrong.

A deficit could arise even with proper management because:

claims were unexpectedly high

a catastrophe occurred

claims severity exceeded reasonable expectations

or other adverse experience occurred.

For example:

Expected claims = RM10m

Actual claims after an unexpected catastrophe = RM15m

The operator may have priced and underwritten prudently, but the PRF still experiences a deficit.

Under the applicable structure, qard may be used to support the fund.

20. But What If the Operator Caused the Deficit Through Negligence or Misconduct?

Now imagine the deficit occurred because the operator:

deliberately underpriced products

ignored proper underwriting standards

accepted inappropriate risks

or otherwise failed to discharge its responsibilities properly.

The source argues that it would be problematic if the operator could simply say:

“The PRF has a deficit. We will lend the PRF money through qard, and the PRF will repay us later.”

Why?

Because ultimately the participants’ fund would still bear the financial consequences of the operator’s own failure.

21. Why an Outright Shareholder Transfer Is Different From Qard

This distinction is extremely important.

Qard

Suppose:

PRF deficit = RM5 million

Shareholders provide:

RM5 million qard

The PRF receives the money, but qard is an interest-free loan that may be repayable from future PRF surpluses according to the applicable rules.

So economically:

Shareholders support PRF now → PRF may repay shareholders later

Outright Transfer

Suppose the same RM5 million deficit resulted from the operator’s failure to discharge its responsibilities properly.

Under the regulatory approach being proposed here:

Shareholders transfer RM5 million to PRF

but it is not treated as qard repayable by the PRF.

Therefore:

Shareholders bear the financial consequence

rather than passing the eventual cost back to participants.

This creates stronger accountability.

22. Why Would This Better Align Interests?

Imagine management knows:

“If we deliberately underprice products to increase Wakalah fees, and this causes a PRF deficit, shareholders may have to cover the resulting deficit without repayment.”

Now shareholders and management have a much stronger incentive to ensure:

proper pricing

proper underwriting

adequate tabarru’

good governance

and

responsible management

Therefore:

Operator causes problem → Operator/shareholder side bears consequence

This helps reduce the conflict of interest.

23. Important - Do Not Assume Every Deficit Must Be Paid by Shareholders Outright

The distinction is:

Genuine adverse claims experience

Operator acted prudently, but unexpectedly bad claims occurred.

→ PRF deficit may be supported through qard, depending on the applicable Takaful framework.

Deficit caused by operator’s failure to properly discharge its responsibilities

For example, negligent or improper underwriting/pricing.

→ The regulatory approach described here argues that shareholders should make an outright transfer rather than qard.

So the principle is:

Participants should not ultimately have to repay shareholders for a deficit that arose because the operator failed in its own responsibilities.

24. Complete Numerical Example

Suppose:

Proper contribution = RM1,000

Wakalah fee = 20%

Adequate tabarru’ = RM800

There are:

10,000 participants

Proper structure:

Total contributions = RM10m

Operator Wakalah fee = RM2m

PRF tabarru’ = RM8m

Everything is actuarially appropriate.

Now suppose the operator aggressively reduces the price to:

RM800

This attracts:

20,000 participants

Total contributions:

RM16m

Operator Wakalah fee:

20% × RM16m = RM3.2m

So the operator’s fee has increased:

RM2m → RM3.2m

But PRF receives:

RM12.8m

Suppose the risks accepted actually require:

RM16m

of adequate risk funding.

The PRF is therefore substantially underfunded relative to the risks accepted.

Eventually, poor claims experience produces a deficit.

So:

Operator benefits from higher turnover

while

Participants suffer through weaker PRF

That is the agent-principal conflict.

Easy Way to Remember

Think of:

FEE vs FUND

The operator wants a sustainable:

FEE

Participants need a sustainable:

FUND

A badly designed incentive can encourage:

More Sales → More Wakalah Fee

while simultaneously causing:

Poor Pricing → Insufficient Tabarru’ → PRF Deficit

Good governance must align the two interests.

Simple Formula

Potential Conflict

Wakalah Fee % × Higher Contribution Turnover = Higher Operator Fee Income

But if growth comes from poor pricing:

Lower Price + Poor Underwriting → Insufficient Tabarru’ → PRF Deficit

Therefore:

Operator Benefit ↑ while Participant Fund Strength ↓

= Agent-Principal Conflict

How to Reduce the Conflict

The solution is not to prevent the operator from earning profit.

A commercially sustainable Takaful operator needs appropriate remuneration.

Instead, governance should ensure that:

Operator profitability

is compatible with:

PRF sustainability and participant interests

So:

Proper Pricing + Prudent Underwriting + Adequate Tabarru’ + Fiduciary Responsibility + Appropriate Accountability = Better Alignment of Operator and Participant Interests

One-Sentence Summary

The agent-principal conflict in Takaful arises because a Wakalah fee based on contribution volume may encourage the operator to maximise sales and fee income, while poor pricing or underwriting can leave insufficient tabarru’ in the Participants’ Risk Fund and cause deficits borne by participants; therefore, the operator’s fiduciary responsibilities and appropriate regulatory accountability are necessary to align the operator’s interests with those of the participants.

Takaful - Product Mis-Selling Risk

Product mis-selling risk arises when a participant is sold or recommended a Takaful product that is unsuitable for their actual needs, financial circumstances, risk profile or objectives, or when the product is not properly explained to them.

Mis-selling does not necessarily mean that the Takaful product itself is bad or non-Shari’ah-compliant.

A product can be:

Shari’ah-compliant

but still be:

unsuitable for a particular participant.

This is the most important distinction.

Shari’ah compliance tells us whether the product complies with Shari’ah requirements. Suitability tells us whether the product is appropriate for that particular customer.

1. What Is Product Mis-Selling?

Suppose Ahmad is 55 years old.

He wants:

simple medical protection

and tells the intermediary:

“My main concern is paying my hospital bills if I become sick.”

Instead, the intermediary recommends a long-term Family Takaful product with a substantial savings/investment component that does not appropriately match Ahmad’s objective.

The product itself may be perfectly legitimate and Shari’ah-compliant.

However, if it does not meet Ahmad’s actual needs and was recommended without proper assessment or explanation, there is a mis-selling risk.

So:

Good product + Wrong participant = Potential mis-selling

2. Mis-Selling Can Begin at the Product Design Stage

Mis-selling is not only a problem caused by an agent at the moment of sale.

The risk can begin much earlier, when the product is being designed.

Therefore, good product governance should start by asking:

Who needs this product, why do they need it, what risks does it create, and how should it be sold?

A badly designed product can make appropriate selling much more difficult.

3. First Question - Do Participants Actually Need This Product?

Before developing a new Takaful product, the operator should determine whether the product addresses a real customer need.

For example, suppose an operator wants to introduce a Family Takaful product requiring:

RM1,000 monthly contribution

with a long-term savings component.

The operator should ask:

“Do our intended participants actually need and have the financial ability to maintain this type of product?”

If the intended customers are low-income households earning RM2,500 per month, a RM1,000 monthly commitment may obviously create affordability and sustainability concerns.

The product might be Shari’ah-compliant, but it may be unsuitable for that target market.

4. Second Question - Who Is the Target Market?

Every product should have an appropriate target market.

This means identifying the type of participant for whom the product was designed.

For example:

A basic Motor Takaful product might target:

vehicle owners requiring motor protection

A Family Takaful protection product might target:

people with dependants who need financial protection against death or disability

A long-term savings-oriented Family Takaful product might target:

participants with long-term savings objectives and the financial ability to maintain contributions

Therefore:

Product Design → Identify Customer Need → Identify Appropriate Target Market

5. Example - Right Product, Wrong Target Market

Suppose Sarah has:

RM3,000 monthly income

and very limited emergency savings.

Her main concern is obtaining affordable medical protection.

An intermediary recommends a Family Takaful savings product requiring:

RM1,200 every month for 20 years.

Even if the product is well designed for wealthier customers seeking long-term savings, it may not be appropriate for Sarah.

The problem is not necessarily:

“This is a bad Takaful product.”

The problem is:

“This product may have been sold to the wrong customer.”

That is why identifying the target market is an important part of preventing mis-selling.

6. Availability of Shari’ah-Compliant Investment Instruments

This becomes particularly important when a Takaful product contains a savings or investment component.

Suppose a Family Takaful product promises or illustrates long-term investment benefits.

The operator must consider whether sufficient suitable Shari’ah-compliant investment instruments are available to invest participants’ funds appropriately.

These might include, depending on the applicable investment mandate:

Sukuk

Shari’ah-compliant equities

Islamic money-market instruments

and other permissible investments.

The operator should not design an investment-oriented product based on unrealistic assumptions about investment opportunities or returns.

7. Example - Savings Component

Suppose Fatimah contributes:

RM500 per month

to a Family Takaful arrangement.

Part provides protection and part is allocated toward savings/investment according to the product structure.

If the sales illustration creates the impression that her savings will grow to a very large amount, she may make her decision based on that expectation.

If the investment return is not guaranteed, this must be properly communicated.

The intermediary should not make a non-guaranteed illustration sound like a guaranteed future benefit.

Otherwise:

Unrealistic investment expectation → Participant misunderstanding → Mis-selling risk

8. What Risks Does the Product Create?

Before launching a product, the operator should identify risks to both sides:

Risks to the Participant

For example:

insufficient protection

investment losses or lower-than-expected returns

inability to maintain future contributions

loss of certain benefits after early termination

exclusions or limitations

misunderstanding of guarantees and non-guaranteed benefits

Risks to the Takaful Operator / Funds

For example:

underpricing

unexpectedly high claims

investment risk

liquidity risk

operational risk

mis-selling and conduct risk

reputational risk

The appropriate risks depend on the particular product.

9. Both Parties Should Understand the Risks

It is not enough for the operator to understand the product.

The participant also needs to understand the material features and risks relevant to their decision.

Suppose Ali buys a Family Takaful product believing:

“If I contribute RM500 every month, I am guaranteed RM500,000 after 20 years.”

But the RM500,000 was merely an illustration based on assumptions rather than a guaranteed amount.

Ali has misunderstood an important feature of the product.

A proper sales process should clearly distinguish:

Guaranteed benefits

from

Non-guaranteed benefits or illustrations

where relevant.

10. Why Are Participants Particularly Vulnerable?

Many participants may not have specialist knowledge of:

Takaful

investments

risk

financial planning

tabarru’

Wakalah fees

investment returns

exclusions

or

surplus arrangements

This creates an information imbalance.

The intermediary may understand the product much better than the participant.

Therefore, the participant often depends heavily on the intermediary’s explanation and advice.

That creates a responsibility for the intermediary to communicate accurately and appropriately.

11. What Is an Intermediary?

An intermediary is the person or organisation between the Takaful operator and the customer in the distribution or sales process.

Depending on the distribution structure, this could include an:

agent

broker

financial adviser

or other authorised distributor.

The intermediary helps connect:

Takaful Operator → Participant

But their role should not simply be:

“Sell as many certificates as possible.”

Where advice is being provided, the intermediary should appropriately understand the participant’s needs and the product being recommended.

12. Protection and Savings Must Both Be Explained

This is particularly important for Family Takaful products containing both protection and savings/investment elements.

Suppose Ahmad contributes:

RM1,000

In a simplified illustration, the money may be allocated between different purposes according to the product structure.

Ahmad needs to understand matters such as:

How much protection am I receiving?

What benefits are guaranteed?

What benefits are not guaranteed?

What fees am I paying?

How does the savings/investment component work?

What happens if I stop contributing early?

What risks am I taking?

A participant should not simply be told:

“This is a good Islamic savings plan.”

That explanation is insufficient for an informed financial decision.

13. “One Size Does Not Fit All”

This phrase means that the same financial product is not appropriate for every person.

Consider three participants.

Ahmad

Age: 25

Single, stable income, wants long-term savings and protection.

His needs may favour one type of Family Takaful structure.

Ali

Age: 40

Married with three children and a housing loan.

His priority may be substantial family protection if he dies or becomes disabled.

Fatimah

Age: 65

Retired and mainly concerned with medical expenses and preserving her existing savings.

Her needs may be completely different.

Therefore:

Same product + Different people ≠ Same suitability

Financial advice should consider the circumstances and objectives of the individual participant.

14. Intermediaries May Lack Sufficient Competence

Another source of mis-selling is insufficient knowledge or competence.

Suppose an agent does not properly understand:

Family Takaful investment risks

fees

exclusions

benefit structure

or

early termination consequences

If the agent does not understand the product properly, it becomes difficult to explain it accurately to the participant.

Therefore:

Poor intermediary knowledge → Poor explanation → Participant misunderstanding → Mis-selling risk

This is why training and competency requirements are important.

15. Intermediaries May Also Be Biased

An even more serious problem can arise when the intermediary’s incentives conflict with the participant’s interests.

Suppose:

Product A commission = RM200

Product B commission = RM800

Product A is more appropriate for Sarah.

But the intermediary recommends Product B primarily because it generates the larger commission.

The participant may believe:

“The adviser recommended Product B because it is best suited to me.”

But the recommendation may actually have been influenced by the intermediary’s financial incentive.

This is an example of a conflict of interest and creates significant mis-selling risk.

16. Why Can Mis-Selling Be Particularly Serious in Takaful?

Takaful has an additional issue: trust based on Shari’ah compliance.

A Muslim participant may think:

“It is Shari’ah-compliant, therefore it must be suitable for me.”

But those are two different questions.

Question 1

Is the product Shari’ah-compliant?

This concerns whether the product and its structure comply with applicable Shari’ah requirements.

Question 2

Is this product suitable for Ahmad?

This concerns Ahmad’s:

income

financial obligations

protection needs

savings objectives

risk tolerance

age

and other relevant circumstances.

A product can satisfy Question 1 but fail Question 2.

17. Shari’ah Compliance Should Not Become a Substitute for Understanding

This is one of the most important lessons.

A participant should not purchase a product merely because:

“It is Islamic, so I trust it.”

Shari’ah compliance is important, but the participant should still understand:

What am I buying?

What does it cover?

What does it exclude?

How much will I pay?

How long must I contribute?

What are the risks?

What happens if I terminate early?

Which benefits are guaranteed?

Which returns are uncertain?

Therefore:

Shari’ah Compliance + Product Understanding + Suitability = Better Participant Protection

18. Example - Misplaced Trust

Suppose Ahmad tells an intermediary:

“I don’t really understand this product, but because it is Takaful and Shari’ah-compliant, I trust that it is suitable.”

The intermediary should not exploit this trust.

Instead, the intermediary should explain the product clearly and assess whether it is appropriate for Ahmad.

If Ahmad later discovers that:

the investment return was not guaranteed

the protection was lower than he expected

or

early termination significantly affects the value he receives

he may feel that he was misled.

The fact that the product was Shari’ah-compliant would not remove the mis-selling concern.

19. Why Regulation of Intermediaries Is Important

Because participants rely heavily on intermediaries, regulators need appropriate rules governing their conduct.

Depending on the regulatory framework, these can address matters such as:

competence and training

clear disclosure

product knowledge

suitability or needs assessment

fair presentation of benefits and risks

management of conflicts of interest

sales incentives

documentation

and

customer complaints

The objective is to reduce the possibility that participants purchase unsuitable products because of poor advice, inadequate information or biased recommendations.

20. Product Governance Is the First Line of Defence

Mis-selling should ideally be prevented before the product reaches the customer.

The process can be understood as:

Identify participant need

↓

Define target market

↓

Design suitable product

↓

Identify participant and operator risks

↓

Ensure adequate Shari’ah-compliant investment opportunities where relevant

↓

Train intermediaries

↓

Explain product clearly

↓

Assess customer needs/suitability where required

↓

Sell to appropriate participant

This is much stronger than waiting until customers complain after purchasing the product.

21. Clear Example of Proper Selling vs Mis-Selling

Suppose Sarah earns:

RM4,000 per month

She tells the intermediary:

“I mainly need affordable protection for my children if I die. I cannot afford a very high monthly commitment.”

Proper approach

The intermediary assesses Sarah’s:

income

dependants

existing protection

financial commitments

and

objectives

The intermediary explains an appropriate Takaful option, including its contribution, benefits, exclusions, fees and risks.

Sarah understands what she is buying.

That is closer to appropriate selling.

Potential mis-selling

The intermediary ignores Sarah’s needs and sells her an expensive savings-oriented product requiring:

RM1,500 per month

because it produces a larger commission.

Sarah cannot sustainably maintain the contributions and did not understand the product.

That is a clear example of mis-selling risk.

Easy Way to Remember

Use:

NEED → TARGET → EXPLAIN → SUITABILITY → SELL

NEED

Does the customer actually need the product?

TARGET

Is the customer part of the appropriate target market?

EXPLAIN

Have the benefits, costs, risks and limitations been properly explained?

SUITABILITY

Does the product fit the participant’s circumstances and objectives?

SELL

Only then should the product be recommended or sold through the appropriate process.

Important Distinction

Shari’ah-compliant does not automatically mean suitable for everyone.

And:

Good investment potential does not automatically mean suitable product.

And:

Good product does not automatically mean good advice.

The product, customer and sales process must all fit together.

Simple Formula

Mis-Selling Risk = Unsuitable Product/Customer Match + Poor Explanation + Inadequate Advice + Intermediary Bias/Conflict

To reduce it:

Good Product Governance + Correct Target Market + Competent Intermediaries + Clear Disclosure + Appropriate Advice = Lower Mis-Selling Risk

One-Sentence Summary

Product mis-selling risk in Takaful arises when participants are sold products that do not appropriately match their needs or circumstances, or when benefits, costs and risks are inadequately explained; because participants may place additional trust in a product simply because it is Shari’ah-compliant, strong product governance, competent and unbiased intermediaries, clear disclosure and appropriate customer assessment are essential.

Takaful - Margin in Pricing

In Takaful pricing, a margin is an additional amount included above the central or best estimate of expected costs to allow for uncertainty and adverse experience.

The basic idea is:

We can estimate future claims, but we cannot know them exactly. Therefore, some financial cushion is needed in the pricing.

For example, an actuary may estimate that expected claims will be RM700 per participant. This does not mean every year will produce exactly RM700 of claims per participant. Actual claims might be RM650, RM750, RM850 or even higher.

A margin provides protection against this uncertainty.

1. What Does “Margin” Mean?

Suppose the expected claims cost for a participant is:

RM700

If the Takaful arrangement prices the risk assuming claims will be exactly RM700, there is no room for adverse deviation.

Instead, suppose an additional:

RM100 margin

is allowed.

Then:

Expected claims = RM700

Margin = RM100

Amount allowed for claims risk and uncertainty:

RM800

The RM100 does not mean the operator expects to spend it.

It means:

“Our best estimate is RM700, but because the future is uncertain, we need an additional cushion.”

2. Why Is Margin Important?

Insurance and Takaful deal with future uncertain events.

The operator prices the product today, but claims occur later.

Suppose 10,000 participants join a Motor Takaful scheme.

The actuary estimates:

Expected claims = RM7 million

But actual claims could turn out to be:

RM6.5 million

or

RM7 million

or

RM8 million

or even more.

Therefore:

Expected Claims ≠ Guaranteed Claims

A margin recognises that actuarial estimates are estimates rather than certainties.

3. Margin Protects Against Claims Being Higher Than Expected

Suppose:

Expected claims = RM7 million

The Takaful pricing provides exactly:

RM7 million

Then actual claims become:

RM7.8 million

The PRF is short by:

RM800,000

Now suppose the pricing had included an appropriate margin of:

RM1 million

The amount provided through the pricing for this simplified illustration would be:

RM7m expected claims + RM1m margin = RM8m

Actual claims:

RM7.8m

The adverse experience can be absorbed more easily.

This illustrates the importance of a margin.

4. Margin Is Important Because Claims Are Volatile

You recently studied claims volatility.

Suppose historical claims were:

Year 1 = RM5 million

Year 2 = RM7 million

Year 3 = RM6 million

Year 4 = RM9 million

Year 5 = RM8 million

Claims clearly fluctuate.

An actuary might estimate the expected future claims at approximately:

RM7 million

But there is no guarantee that next year’s claims will equal RM7 million.

Therefore:

Claims volatility → uncertainty → need for an appropriate margin

5. Where Does the Margin Come From?

The margin is not simply an arbitrary amount chosen by management.

Actuaries generally estimate it by analysing the uncertainty surrounding expected future claims and other relevant assumptions.

A simplified pricing process is:

Historical data

↓

Estimate future claims

↓

Measure uncertainty around that estimate

↓

Allow for adverse deviation/risk

↓

Determine an appropriate margin

The exact actuarial method can be much more sophisticated and depends on the product, data, regulatory framework and pricing methodology.

6. Step 1 - Examine Historical Claims

Suppose a Motor Takaful operator has 100,000 similar participants.

Historical claims per participant were approximately:

Year 1 = RM620

Year 2 = RM680

Year 3 = RM710

Year 4 = RM760

Year 5 = RM730

Actuaries analyse this information.

But they should not simply calculate an average and stop there.

They also consider whether future experience may be different.

7. Step 2 - Estimate Expected Future Claims

Suppose actuarial analysis concludes that next year’s expected claims cost is:

RM720 per participant

This is called the expected claim cost or, depending on context, a best-estimate claim cost.

It means:

Based on the available information and assumptions, RM720 is our central estimate of the expected claims cost.

But RM720 is still only an estimate.

8. Step 3 - Consider What Could Make Actual Claims Higher

The actuary considers various sources of uncertainty.

For Motor Takaful, for example:

more accidents than expected

larger claims than expected

higher repair costs

medical inflation

changes in driving behaviour

catastrophe events

changes in claim frequency

changes in claim severity

limited or unreliable historical data

All of these can cause:

Actual Claims > Expected Claims

Therefore, an additional margin may be appropriate.

9. Step 4 - Quantify the Uncertainty

This is where actuarial and statistical methods become important.

Actuaries may analyse the distribution of possible future claims, rather than looking at only one expected number.

Imagine the expected claim cost is:

RM720

But modelling indicates that actual experience could reasonably be higher.

Instead of pricing exactly at RM720, an additional amount may be allowed for uncertainty.

For a simplified example:

Expected claims = RM720

Risk/uncertainty margin = RM80

Therefore:

RM720 + RM80 = RM800

The RM80 is the additional cushion against adverse claims experience.

10. Margin Can Be Expressed as a Percentage

A simple illustration is to apply a percentage to expected claims.

Suppose:

Expected claims = RM700

Assume an illustrative margin of:

10%

Then:

Margin = RM700 × 10%

= RM70

Therefore:

Expected claims + margin

= RM700 + RM70

= RM770

But remember: 10% is only an example.

There is no universal rule saying every Takaful product should have a 10% margin.

The appropriate margin depends on the actual risk and applicable actuarial/regulatory requirements.

11. Higher Uncertainty May Require a Higher Margin

Imagine two Takaful portfolios.

Portfolio A - Large and Predictable

There are:

500,000 Motor Takaful participants

The operator has many years of reliable claims data.

Claims are relatively predictable.

The uncertainty around the expected claim estimate may therefore be relatively lower.

Portfolio B - New and Uncertain

There are:

2,000 participants

The product is new.

There is very little historical data.

Claims can be extremely large.

The uncertainty is much greater.

Therefore, all else equal:

Greater uncertainty → potentially greater required margin

This connects directly with risk pooling.

12. Connection Between Risk Pooling and Margin

Remember:

Large + diversified pool → generally more predictable aggregate claims

More predictable claims can reduce uncertainty.

Therefore:

Better Risk Pooling

↓

More Predictable Claims

↓

Lower Relative Uncertainty

↓

Potentially Less Need for Margin for That Particular Uncertainty

But this does not mean a large pool needs no margin.

Catastrophe risk, concentration, inflation and other uncertainties may still exist.

13. Example - Small Pool vs Large Pool

Suppose only 100 people participate.

Expected claims:

RM100,000

If just a few unexpected large claims occur, actual claims might become:

RM180,000

That is a major deviation.

Now imagine:

100,000 well-diversified participants

The law of large numbers can make aggregate claims experience relatively more predictable, assuming the risks are sufficiently independent and diversified.

Therefore, the uncertainty relative to the size of the portfolio may be lower.

This is one reason risk pooling, diversification and pricing margins are connected.

14. Margin Is Not the Same as Wakalah Fee

This distinction is extremely important.

Wakalah Fee

The Wakalah fee is remuneration paid to the Takaful operator for managing the Takaful arrangement.

For example:

RM200

It supports activities such as administration, underwriting, distribution, claims management and operations according to the applicable model.

Margin

A risk/pricing margin, in the sense we are discussing, is an allowance for uncertainty and adverse experience.

For example:

Expected claims = RM700

Margin = RM70

Required claims-related pricing allowance = RM770

Therefore:

Wakalah Fee ≠ Risk Margin

15. Margin Is Also Not the Same as Surplus

This is another important distinction.

Margin

Included when pricing the risk, before we know what actual claims will be.

It is based on uncertainty about the future.

Surplus

Determined after actual financial experience develops and the relevant claims, expenses, Retakaful, provisions and other obligations are taken into account.

So:

Margin = forward-looking allowance for uncertainty

Surplus = financial result that may emerge after experience occurs

16. A Margin Can Contribute to a Future Surplus, But They Are Not the Same

Suppose:

Expected claims = RM7 million

Margin included in pricing = RM1 million

So the claims-related pricing allowance is:

RM8 million

Now actual claims turn out to be only:

RM6.5 million

The favourable claims experience may contribute to an underwriting surplus, after considering all other relevant items.

But suppose actual claims are:

RM7.9 million

Much of the margin has effectively been needed to absorb the adverse experience.

Therefore, you should not think:

“Margin automatically becomes surplus.”

It does not.

The margin is there because actual experience is uncertain.

17. Connection With Tabarru’ Adequacy

This is particularly important for the issue you just studied.

Suppose actuarial analysis determines that the PRF needs:

Expected claims = RM700

Risk margin = RM100

Therefore, the PRF needs an actuarially adequate allocation of approximately:

RM800

Now the participant pays:

Total contribution = RM1,000

Suppose the Wakalah fee is:

RM200

Therefore:

Tabarru’ to PRF = RM800

The PRF receives the amount required in this simplified example.

18. What If the Wakalah Fee Is Too High?

Keep everything else the same.

Total contribution:

RM1,000

But Wakalah fee:

RM300

Therefore:

Tabarru’ to PRF = RM700

Yet actuarial analysis says the PRF needs:

Expected claims RM700 + margin RM100 = RM800

Therefore:

Required PRF allocation = RM800

Actual PRF allocation = RM700

Shortfall:

RM100

This is precisely why it is not enough to say:

“The participant’s total RM1,000 contribution looks reasonable.”

We must ask:

“Is the amount actually entering the PRF sufficient, including an appropriate allowance for uncertainty?”

19. Why Is Margin Important for Solvency?

Without an adequate margin, even relatively small adverse deviations from expected claims can create deficits.

For example:

Expected claims = RM10m

PRF pricing allowance = RM10m

Actual claims = RM11m

Shortfall = RM1m

If this happens repeatedly, the PRF can become financially weak.

With prudent pricing, appropriate reserves, Retakaful, accumulated surplus and suitable margins, the PRF has greater capacity to withstand adverse experience.

Therefore:

Margin → greater protection against uncertainty → stronger PRF → lower probability of financial distress

But margin alone does not guarantee solvency.

20. Margin Is Only One Layer of Protection

A Takaful operation should not simply charge a huge margin and assume the problem is solved.

Financial strength comes from several mechanisms working together:

Proper pricing

Appropriate margin

Good risk pooling

Diversification

Prudent claims reserves

Retakaful

Accumulated surplus

Capital

Strong underwriting

Good risk management

Margin is therefore one component of financial prudence, not a substitute for all the others.

Easy Example to Remember

Suppose an actuary says:

“Based on our data, Ahmad’s expected claims cost is RM700. But RM700 is only our best estimate. Actual claims could be higher, so we allow another RM100 for uncertainty.”

Therefore:

Expected Claims = RM700

• ●

Margin = RM100

=

RM800 required for the risk

Now suppose:

Total contribution = RM1,000

Wakalah fee = RM200

Tabarru’ = RM800

Then the PRF receives the required RM800.

This is a very simple way of seeing how:

Pricing → Margin → Wakalah Fee → Tabarru’ Adequacy

are connected.

Easy Way to Remember

Think of ESTIMATE + CUSHION.

Expected claims = ESTIMATE

Margin = CUSHION

So:

Margin is the cushion added because the actuarial estimate of future claims may turn out to be wrong.

Simple Formula

At its simplest:

Required Risk Price = Expected Claims + Appropriate Margin for Uncertainty

For example:

RM700 + RM100 = RM800

Then, under a simplified Wakalah structure:

Total Contribution − Wakalah Fee = Tabarru’ allocated to PRF

The important test is:

Tabarru’ to PRF ≥ Expected Claims + Appropriate Risk Margin + Other Relevant PRF Requirements

Connection With the Concepts You Have Learned

Historical Claims Data

↓

Estimate Future Claims

↓

Recognise Claims Are Uncertain

↓

Add Appropriate Margin

↓

Determine Adequate PRF Requirement

↓

Ensure Wakalah Fee Does Not Leave Insufficient Tabarru’

↓

Adequately Funded PRF

↓

Better Ability to Absorb Claims Volatility

↓

Lower Risk of Deficit and Insolvency

One-Sentence Summary

A margin in Takaful pricing is an additional actuarial allowance above the expected or best-estimate cost to protect against uncertainty and adverse future experience; its size is derived from the nature, variability and uncertainty of the risks rather than being an arbitrary amount, and an appropriate margin helps ensure that the tabarru’ allocated to the Participants’ Risk Fund is sufficient to withstand claims that turn out worse than expected.

Takaful - Pricing, Solvency Risk and Adequacy of Tabarru’

Pricing in Takaful is slightly different from pricing in conventional insurance because the initial contribution paid by a participant may not necessarily represent the participant’s ultimate net cost of protection.

This is because a Takaful risk fund may generate an underwriting surplus, and depending on the applicable Takaful model, regulations and certificate terms, some surplus may eventually be distributed to eligible participants.

Therefore, when considering Takaful pricing, we need to understand three important issues:

1. Initial contribution versus ultimate cost of cover

2. Adequate pricing and solvency

3. Adequacy of the tabarru’ remaining after the Wakalah fee

1. The Takaful Contribution Is the Initial Amount Paid

Suppose Ahmad purchases a Takaful certificate and pays:

RM1,000 contribution

At the beginning, Ahmad pays the full:

RM1,000

However, depending on the structure of the Takaful arrangement, Ahmad may later become eligible for a distribution from the underwriting surplus.

For example:

Initial contribution = RM1,000

Later surplus distribution = RM100

Simplified ultimate net cost:

RM1,000 − RM100 = RM900

This is why the contribution paid at the beginning is not necessarily the ultimate economic cost of the cover.

2. Similarity With a Mutual Insurer

This idea is similar to insurance provided by a mutual insurer.

In a mutual structure, policyholders collectively participate in the mutual arrangement, and depending on financial performance and the applicable rules, they may receive a dividend or similar distribution.

For example:

Initial payment = RM1,000

Eventual dividend = RM80

Simplified ultimate cost:

RM1,000 − RM80 = RM920

Similarly, in Takaful:

Initial contribution − eventual eligible surplus distribution = simplified ultimate net cost

However, a surplus distribution is not guaranteed. It depends on the actual performance of the risk fund and the applicable surplus policy.

3. Why Takaful Operators Should Not Focus Only on Price Competition

If two Takaful operators compete only by offering the lowest initial contribution, they may create financial problems.

Suppose:

Operator A contribution = RM1,000

Operator B contribution = RM850

Customers may immediately think:

“Operator B is cheaper, so it must be better.”

But this does not tell us whether RM850 is sufficient to support the underlying risk.

Operator A may have:

proper pricing

adequate tabarru’

strong claims reserves

appropriate Retakaful

and

a financially healthy PRF

Operator B may simply have reduced its price aggressively to attract customers.

Therefore:

Lower contribution ≠ automatically better Takaful

The contribution must first be financially sustainable.

4. Why Regulation Is Necessary

Takaful participants pay contributions before they know whether they will make a claim.

For example, Sarah buys a Family Takaful certificate today.

She may not make a claim for:

5 years, 10 years, 20 years or even longer, depending on the nature of the certificate.

Therefore, it is important that the Takaful operation remains financially sound and capable of meeting its obligations when covered claims eventually arise.

This is why regulators need to pay attention to:

pricing adequacy

capital and solvency

claims reserves

risk management

and

adequacy of the PRF

5. What Is Insolvency Risk?

Insolvency risk is the risk that the Takaful arrangement becomes financially unable to meet its obligations, including paying valid claims when they fall due.

In simple words:

The participant has a valid claim, but insufficient financial resources are available to meet the obligation.

Suppose a PRF has:

RM20 million available

but its claims and other obligations amount to:

RM30 million

If the deficit cannot be adequately addressed through the available financial mechanisms, serious solvency problems may arise.

Therefore, insolvency risk must be kept as low as reasonably possible.

6. Appropriate Product Pricing Is Essential

A Takaful operator must have a proper product pricing mechanism.

This means the contribution should be calculated carefully based on the underlying risks and expected costs.

For example, actuaries may consider:

expected frequency of claims

expected severity of claims

participant characteristics

historical claims experience

expenses

Retakaful costs

risk margins

reserves and capital requirements

and other relevant factors.

The objective is not simply:

“What is the lowest contribution we can charge?”

Instead:

“What contribution is sufficient and sustainable for the risks being covered?”

7. Example of Proper Pricing

Suppose the expected financial requirements associated with a particular risk are estimated as:

Expected claims = RM700

Relevant costs = RM150

Required margin/buffer = RM100

Simplified required total:

RM950

If the operator charges:

RM1,000

the pricing may provide an adequate margin based on those assumptions.

But if intense price competition causes the operator to charge:

RM750

while expected claims alone are RM700, there may be very little room for the other necessary costs and financial buffers.

Repeated underpricing can weaken the financial sustainability of the Takaful arrangement.

8. Prudent Claims Reserving Is Also Important

Correct pricing alone is not enough.

The Takaful operation also needs prudent claims reserves.

A claims reserve is money or a financial provision set aside for claims that the fund expects it will need to pay.

For example, a participant has already suffered a covered accident.

The final claim has not yet been settled, but the operator estimates that it will cost:

RM500,000

The PRF should recognise an appropriate provision for that expected obligation.

It should not treat the RM500,000 as freely available surplus merely because the claim has not yet been physically paid.

9. Example of Why Claims Reserving Matters

Suppose the PRF has:

RM10 million

It has already paid:

RM6 million claims

At first, someone might think:

RM10m − RM6m = RM4m remaining

But suppose there are outstanding valid claims expected to cost:

RM3 million

Then the fund cannot simply treat the entire RM4 million as surplus.

It needs to provide for those outstanding claims.

Simplified:

RM10m − RM6m paid claims − RM3m claims provision = RM1m

This is why prudent claims reserving protects solvency.

10. A Risk Specific to the Takaful Structure

There is another important pricing issue in Takaful.

Even if the total Takaful contribution is actuarially sound, the amount actually entering the Participants’ Risk Fund may still be inadequate.

Why?

Because under the Wakalah model, part of the contribution may be deducted as a:

Wakalah fee

The remaining amount is allocated as tabarru’ to the PRF.

So we must distinguish:

Total Takaful Contribution

from

Amount Actually Entering the PRF

11. Example - Total Contribution Is Adequate, But Tabarru’ Is Not

Suppose an actuary determines that:

Total Takaful contribution = RM1,000

At first, RM1,000 appears actuarially reasonable.

Now suppose:

Wakalah fee = RM300

Therefore:

RM1,000 − RM300 = RM700

Only:

RM700

is allocated to the PRF as tabarru’ in this simplified example.

Now suppose the expected claims burden allocated to the PRF is:

RM800

There is a problem:

Tabarru’ = RM700

Expected claims requirement = RM800

Shortfall:

RM100

Therefore:

The total contribution may be adequate overall, but the amount allocated to the risk fund is inadequate to support the risks borne by that fund.

12. Why Is This Particularly Important in Takaful?

Because the PRF is the fund that bears the participants’ underwriting risk.

Remember:

Participant → pays total contribution

Then, under a simplified Wakalah structure:

Total Contribution

↓

Wakalah Fee → Operator Fund

• ●

Tabarru’ → Participants’ Risk Fund

The PRF then pays covered claims.

Therefore, it is not enough to ask:

“Is the total contribution adequate?”

We must also ask:

“After deducting the Wakalah fee, is the amount entering the PRF adequate for the risks borne by the PRF?”

This is the crucial distinction.

13. Large-Scale Example

Suppose there are:

10,000 participants

Each pays:

RM1,000

Total contributions:

RM10 million

Suppose:

Wakalah fee = 30%

Therefore:

RM3 million → operator

and:

RM7 million → PRF

Now suppose expected claims and relevant PRF obligations are:

RM8 million

The PRF receives:

RM7 million

but needs approximately:

RM8 million

Expected shortfall:

RM1 million

So:

RM7m − RM8m = −RM1m

This creates a risk of a PRF deficit.

14. Why Regulation Should Consider the Tabarru’ Amount Separately

This leads to an important regulatory principle.

It is not sufficient for regulation to check only whether:

Total contribution = actuarially adequate

Regulation should also ensure that:

Contribution actually allocated to the Takaful risk fund = actuarially adequate for the risks and obligations borne by that fund.

Otherwise, an operator could theoretically charge a reasonable total contribution but allocate too much to the Wakalah fee, leaving the PRF financially weak.

15. Connection With Qard

Suppose excessive Wakalah deductions contribute to repeated PRF deficits.

The pattern could become:

Participants pay contributions

↓

Large Wakalah fee deducted

↓

Insufficient tabarru’ enters PRF

↓

Claims exceed PRF resources

↓

PRF deficit

↓

Qard required from shareholder/operator fund

This is not a desirable long-term financial structure.

Qard can provide important support when genuine adverse claims experience creates a deficit, but the PRF should not be systematically underfunded because its contribution allocation was inadequate from the beginning.

16. Connection With Surplus

Now we can connect this to your previous question about surplus.

Suppose:

Tabarru’ entering PRF = RM10 million

Claims and relevant obligations = RM8 million

Simplified surplus:

RM2 million

But suppose a larger Wakalah fee means only:

RM7 million

enters the PRF while obligations remain:

RM8 million

Then:

RM7m − RM8m = −RM1m

Instead of having a surplus, the PRF has a:

RM1 million deficit

Therefore, the allocation of the total contribution between the operator and the PRF can have a major effect on the financial health of the risk fund.

17. Does This Mean Wakalah Fees Should Always Be Low?

Not necessarily.

The Takaful operator has genuine operating expenses.

It needs resources for activities such as:

staff

underwriting

claims administration

technology

distribution

regulatory compliance

Shari’ah governance

and other management functions.

Therefore, the objective is not:

“Make the Wakalah fee as small as possible.”

Instead, the objective is to achieve a sustainable balance:

Adequate Wakalah Fee → Sustainable Operator

and

Adequate Tabarru’ → Sustainable PRF

Both sides need to be financially viable.

Easy Way to Remember

There are three pricing questions in Takaful:

1. Is the total contribution reasonable?

RM1,000 total contribution

↓

2. Is the Wakalah fee reasonable?

Suppose:

RM300 Wakalah fee

↓

3. Is the remaining tabarru’ sufficient for the PRF?

RM1,000 − RM300 = RM700 tabarru’

If the PRF requires approximately RM800 to support the expected risk:

RM700 < RM800

Then there is an adequacy problem.

Simple Formula

Participant’s Initial Contribution

Total Takaful Contribution = Wakalah Fee + Tabarru’ + Other Applicable Allocations

Then:

PRF Adequacy

Tabarru’ allocated to PRF ≥ Expected Claims + Relevant PRF Costs + Required Provisions/Margins

If this condition is not reasonably satisfied:

Insufficient Tabarru’ → Greater Deficit Risk → Greater Qard/Solvency Pressure

Connection of All the Concepts

You can now connect the topics you have been studying:

Correct Pricing

↓

Participants pay an adequate contribution

↓

Reasonable Wakalah Fee

↓

Adequate tabarru’ enters the PRF

↓

Good Risk Pooling + Proper Underwriting + Retakaful

↓

Claims are managed effectively

↓

Possible Underwriting Surplus

↓

Surplus can strengthen the PRF

↓

Stronger PRF

↓

Less reliance on shareholder qard

↓

Lower Insolvency Risk

One-Sentence Summary

Takaful pricing should not focus merely on offering the lowest contribution; both the total contribution and, importantly, the tabarru’ actually allocated to the Participants’ Risk Fund after deducting the Wakalah fee must be actuarially adequate, supported by prudent claims reserving and sound risk management, so that the PRF can meet future claims and minimise the risk of insolvency.

1. The Takaful Contribution Is the Initial Amount Paid Suppose Ahmad purchases a Takaful certificate and pays: RM1,000 contribution At the beginning, Ahmad pays the full: RM1,000 However, depending on the structure of the Takaful arrangement, Ahmad may later become eligible for a distribution from the underwriting surplus. For example: Initial contribution = RM1,000 Later surplus distribution = RM100 Simplified ultimate net cost: RM1,000 − RM100 = RM900 This is why the contribution paid at the beginning is not necessarily the ultimate economic cost of the cover. 

2. Similarity With a Mutual Insurer This idea is similar to insurance provided by a mutual insurer. In a mutual structure, policyholders collectively participate in the mutual arrangement, and depending on financial performance and the applicable rules, they may receive a dividend or similar distribution. For example: Initial payment = RM1,000 Eventual dividend = RM80 Simplified ultimate cost: RM1,000 − RM80 = RM920 Similarly, in Takaful: Initial contribution − eventual eligible surplus distribution = simplified ultimate net cost However, a surplus distribution is not guaranteed. It depends on the actual performance of the risk fund and the applicable surplus policy. 

3. Why Takaful Operators Should Not Focus Only on Price Competition If two Takaful operators compete only by offering the lowest initial contribution, they may create financial problems. Suppose: Operator A contribution = RM1,000 Operator B contribution = RM850 Customers may immediately think: “Operator B is cheaper, so it must be better.” But this does not tell us whether RM850 is sufficient to support the underlying risk. Operator A may have: proper pricing adequate tabarru’ strong claims reserves appropriate Retakaful and a financially healthy PRF Operator B may simply have reduced its price aggressively to attract customers. Therefore: Lower contribution ≠ automatically better Takaful The contribution must first be financially sustainable. 

4. Why Regulation Is Necessary Takaful participants pay contributions before they know whether they will make a claim. For example, Sarah buys a Family Takaful certificate today. She may not make a claim for: 5 years, 10 years, 20 years or even longer, depending on the nature of the certificate. Therefore, it is important that the Takaful operation remains financially sound and capable of meeting its obligations when covered claims eventually arise. This is why regulators need to pay attention to: pricing adequacy capital and solvency claims reserves risk management and adequacy of the PRF 

5. What Is Insolvency Risk? Insolvency risk is the risk that the Takaful arrangement becomes financially unable to meet its obligations, including paying valid claims when they fall due. In simple words: The participant has a valid claim, but insufficient financial resources are available to meet the obligation. Suppose a PRF has: RM20 million available but its claims and other obligations amount to: RM30 million If the deficit cannot be adequately addressed through the available financial mechanisms, serious solvency problems may arise. Therefore, insolvency risk must be kept as low as reasonably possible. 

6. Appropriate Product Pricing Is Essential A Takaful operator must have a proper product pricing mechanism. This means the contribution should be calculated carefully based on the underlying risks and expected costs. For example, actuaries may consider: expected frequency of claims expected severity of claims participant characteristics historical claims experience expenses Retakaful costs risk margins reserves and capital requirements and other relevant factors. The objective is not simply: “What is the lowest contribution we can charge?” Instead: “What contribution is sufficient and sustainable for the risks being covered?” 

7. Example of Proper Pricing Suppose the expected financial requirements associated with a particular risk are estimated as: Expected claims = RM700 Relevant costs = RM150 Required margin/buffer = RM100 Simplified required total: RM950 If the operator charges: RM1,000 the pricing may provide an adequate margin based on those assumptions. But if intense price competition causes the operator to charge: RM750 while expected claims alone are RM700, there may be very little room for the other necessary costs and financial buffers. Repeated underpricing can weaken the financial sustainability of the Takaful arrangement. 

8. Prudent Claims Reserving Is Also Important Correct pricing alone is not enough. The Takaful operation also needs prudent claims reserves. A claims reserve is money or a financial provision set aside for claims that the fund expects it will need to pay. For example, a participant has already suffered a covered accident. The final claim has not yet been settled, but the operator estimates that it will cost: RM500,000 The PRF should recognise an appropriate provision for that expected obligation. It should not treat the RM500,000 as freely available surplus merely because the claim has not yet been physically paid. 

9. Example of Why Claims Reserving Matters Suppose the PRF has: RM10 million It has already paid: RM6 million claims At first, someone might think: RM10m − RM6m = RM4m remaining But suppose there are outstanding valid claims expected to cost: RM3 million Then the fund cannot simply treat the entire RM4 million as surplus. It needs to provide for those outstanding claims. Simplified: RM10m − RM6m paid claims − RM3m claims provision = RM1m This is why prudent claims reserving protects solvency. 

10. A Risk Specific to the Takaful Structure There is another important pricing issue in Takaful. Even if the total Takaful contribution is actuarially sound, the amount actually entering the Participants’ Risk Fund may still be inadequate. Why? Because under the Wakalah model, part of the contribution may be deducted as a: Wakalah fee The remaining amount is allocated as tabarru’ to the PRF. So we must distinguish: Total Takaful Contribution from Amount Actually Entering the PRF 

11. Example - Total Contribution Is Adequate, But Tabarru’ Is Not Suppose an actuary determines that: Total Takaful contribution = RM1,000 At first, RM1,000 appears actuarially reasonable. Now suppose: Wakalah fee = RM300 Therefore: RM1,000 − RM300 = RM700 Only: RM700 is allocated to the PRF as tabarru’ in this simplified example. Now suppose the expected claims burden allocated to the PRF is: RM800 There is a problem: Tabarru’ = RM700 Expected claims requirement = RM800 Shortfall: RM100 Therefore: The total contribution may be adequate overall, but the amount allocated to the risk fund is inadequate to support the risks borne by that fund. 

12. Why Is This Particularly Important in Takaful? Because the PRF is the fund that bears the participants’ underwriting risk. Remember: Participant → pays total contribution Then, under a simplified Wakalah structure: Total Contribution ↓ Wakalah Fee → Operator Fund  ●  Tabarru’ → Participants’ Risk Fund The PRF then pays covered claims. Therefore, it is not enough to ask: “Is the total contribution adequate?” We must also ask: “After deducting the Wakalah fee, is the amount entering the PRF adequate for the risks borne by the PRF?” This is the crucial distinction. 

13. Large-Scale Example Suppose there are: 10,000 participants Each pays: RM1,000 Total contributions: RM10 million Suppose: Wakalah fee = 30% Therefore: RM3 million → operator and: RM7 million → PRF Now suppose expected claims and relevant PRF obligations are: RM8 million The PRF receives: RM7 million but needs approximately: RM8 million Expected shortfall: RM1 million So: RM7m − RM8m = −RM1m This creates a risk of a PRF deficit. 

14. Why Regulation Should Consider the Tabarru’ Amount Separately This leads to an important regulatory principle. It is not sufficient for regulation to check only whether: Total contribution = actuarially adequate Regulation should also ensure that: Contribution actually allocated to the Takaful risk fund = actuarially adequate for the risks and obligations borne by that fund. Otherwise, an operator could theoretically charge a reasonable total contribution but allocate too much to the Wakalah fee, leaving the PRF financially weak. 

15. Connection With Qard Suppose excessive Wakalah deductions contribute to repeated PRF deficits. The pattern could become: Participants pay contributions ↓ Large Wakalah fee deducted ↓ Insufficient tabarru’ enters PRF ↓ Claims exceed PRF resources ↓ PRF deficit ↓ Qard required from shareholder/operator fund This is not a desirable long-term financial structure. Qard can provide important support when genuine adverse claims experience creates a deficit, but the PRF should not be systematically underfunded because its contribution allocation was inadequate from the beginning. 

16. Connection With Surplus Now we can connect this to your previous question about surplus. Suppose: Tabarru’ entering PRF = RM10 million Claims and relevant obligations = RM8 million Simplified surplus: RM2 million But suppose a larger Wakalah fee means only: RM7 million enters the PRF while obligations remain: RM8 million Then: RM7m − RM8m = −RM1m Instead of having a surplus, the PRF has a: RM1 million deficit Therefore, the allocation of the total contribution between the operator and the PRF can have a major effect on the financial health of the risk fund. 

17. Does This Mean Wakalah Fees Should Always Be Low? Not necessarily. The Takaful operator has genuine operating expenses. It needs resources for activities such as: staff underwriting claims administration technology distribution regulatory compliance Shari’ah governance and other management functions. Therefore, the objective is not: “Make the Wakalah fee as small as possible.” Instead, the objective is to achieve a sustainable balance: Adequate Wakalah Fee → Sustainable Operator and Adequate Tabarru’ → Sustainable PRF Both sides need to be financially viable. 

Easy Way to Remember There are three pricing questions in Takaful: 1. Is the total contribution reasonable? RM1,000 total contribution ↓ 2. Is the Wakalah fee reasonable? Suppose: RM300 Wakalah fee ↓ 3. Is the remaining tabarru’ sufficient for the PRF? RM1,000 − RM300 = RM700 tabarru’ If the PRF requires approximately RM800 to support the expected risk: RM700 < RM800 Then there is an adequacy problem. 

Simple Formula Participant’s Initial Contribution Total Takaful Contribution = Wakalah Fee + Tabarru’ + Other Applicable Allocations Then: PRF Adequacy Tabarru’ allocated to PRF ≥ Expected Claims + Relevant PRF Costs + Required Provisions/Margins If this condition is not reasonably satisfied: Insufficient Tabarru’ → Greater Deficit Risk → Greater Qard/Solvency Pressure 

Connection of All the Concepts You can now connect the topics you have been studying: Correct Pricing ↓ Participants pay an adequate contribution ↓ Reasonable Wakalah Fee ↓ Adequate tabarru’ enters the PRF ↓ Good Risk Pooling + Proper Underwriting + Retakaful ↓ Claims are managed effectively ↓ Possible Underwriting Surplus ↓ Surplus can strengthen the PRF ↓ Stronger PRF ↓ Less reliance on shareholder qard ↓ Lower Insolvency Risk 

One-Sentence Summary Takaful pricing should not focus merely on offering the lowest contribution; both the total contribution and, importantly, the tabarru’ actually allocated to the Participants’ Risk Fund after deducting the Wakalah fee must be actuarially adequate, supported by prudent claims reserving and sound risk management, so that the PRF can meet future claims and minimise the risk of insolvency.

Takaful - Risk of Wakalah Fee Making the Tabarru’ Insufficient

This means that even when the total Takaful contribution charged to the participant appears sufficient, the Participants’ Risk Fund (PRF) can still become financially weak if too much of that contribution is deducted as a Wakalah fee.

The key issue is:

Claims are paid from the PRF, but the whole contribution does not necessarily enter the PRF.

1. Start With the Total Takaful Contribution

Suppose actuaries calculate that the appropriate total contribution for a Motor Takaful participant is:

RM1,000

The RM1,000 may appear actuarially sound and adequate.

This means the contribution has been calculated based on factors such as:

expected claims

risk characteristics

expenses

claims frequency and severity

required financial margins

So at first sight:

RM1,000 looks sufficient.

2. But the Entire RM1,000 Does Not Necessarily Enter the Risk Fund

Under a Wakalah model, the Takaful operator receives a Wakalah fee for managing the Takaful operation.

Suppose:

Total contribution = RM1,000

Wakalah fee = RM300

Remaining tabarru’ = RM700

Therefore:

RM1,000 − RM300 = RM700

Only RM700 goes into the PRF in this simplified example.

So although the participant paid RM1,000:

Participant pays RM1,000

↓

RM300 → Takaful operator as Wakalah fee

RM700 → PRF as tabarru’

3. Where Does the Problem Arise?

Suppose the expected claims cost per participant is:

RM750

But only:

RM700

enters the PRF.

Now there is a problem:

Expected claims = RM750

Tabarru’ available = RM700

Therefore:

RM700 − RM750 = −RM50

The PRF is short by RM50 per participant before considering any other relevant risk-fund obligations.

So:

The total RM1,000 contribution may look adequate, but the portion actually available to bear underwriting risk may be inadequate.

That is the specific risk being described.

4. Example With 10,000 Participants

This becomes much clearer on a larger scale.

Suppose:

10,000 participants × RM1,000

Total Takaful contributions:

RM10 million

Now suppose the operator deducts a 30% Wakalah fee:

Wakalah fee = RM3 million

Remaining tabarru’ entering PRF:

RM7 million

But expected claims are:

RM7.5 million

Therefore:

PRF income = RM7m

Expected claims = RM7.5m

Expected shortfall:

RM500,000

So even though:

RM10 million of total contributions was collected

the fund actually responsible for claims receives only:

RM7 million

That is why the allocation between Wakalah fee and tabarru’ matters enormously.

5. What Does “Actuarially Sound” Mean?

Actuarially sound means the contribution has been calculated using reasonable statistical and actuarial assumptions about the risks and expected costs.

For example, actuaries might calculate:

Expected claims = RM750

Operating expenses = RM150

Financial/risk margin = RM100

Therefore:

Required total contribution = RM1,000

That may be perfectly reasonable as an overall price.

But the Takaful structure creates another question:

After deducting the operator’s Wakalah fee, is enough money actually being allocated to the PRF to support its claims and other obligations?

This question is particularly important in Takaful.

6. The Wakalah Fee Is Not Available to Pay PRF Claims

Once the agreed Wakalah fee is allocated to the operator under the applicable structure, it represents the operator’s remuneration for managing the Takaful arrangement.

It should therefore not simply be assumed that:

RM1,000 participant contribution = RM1,000 available for claims

Instead:

Total Contribution − Wakalah Fee − other applicable allocations = Amount allocated to PRF

The PRF must then be financially adequate based on the amount actually allocated to it.

7. Why Can a High Wakalah Fee Be Dangerous?

Imagine two Takaful arrangements collecting the same contribution:

RM1,000 per participant

Operator A

Wakalah fee = RM150

Tabarru’ to PRF = RM850

Operator B

Wakalah fee = RM350

Tabarru’ to PRF = RM650

Suppose expected claims are:

RM750 per participant

Operator A’s PRF receives RM850 against expected claims of RM750.

But Operator B’s PRF receives only RM650 against expected claims of RM750.

Therefore, Operator B’s PRF could face persistent financial pressure.

The problem is not necessarily that the total contribution is too low.

The problem may be:

too little of the total contribution is reaching the risk fund.

8. This Can Lead to a PRF Deficit

Suppose:

Tabarru’ received by PRF = RM7 million

Claims and relevant obligations = RM8 million

Then:

RM7m − RM8m = −RM1 million

The PRF has a:

RM1 million deficit

Where the applicable Takaful structure requires shareholder support, the operator/shareholder fund may then have to provide qard.

So there can be an undesirable cycle:

High Wakalah Fee

↓

Less Tabarru’ enters PRF

↓

PRF insufficient for claims

↓

PRF deficit

↓

Qard may be required

↓

Future PRF surpluses may need to repay qard

This can weaken the long-term financial sustainability of the mutual risk fund.

9. Connection With Your Previous Question About Surplus

This is directly connected to surplus.

Suppose the PRF receives:

RM10 million tabarru’

and its claims, Retakaful costs and relevant provisions total:

RM8 million

There may be:

RM2 million surplus

But if a large Wakalah fee means only:

RM7 million

reaches the PRF while its obligations are RM8 million:

RM7m − RM8m = −RM1m

Now there is a:

RM1 million deficit

Therefore:

Higher amount entering PRF → greater ability to pay claims and potentially build surplus

whereas:

Insufficient tabarru’ → greater probability of deficit and qard dependence

10. Does This Mean Wakalah Fees Are Bad?

No.

The Takaful operator needs to be compensated for providing services such as:

underwriting

claims administration

staff and systems

distribution

regulatory compliance

Shari’ah governance

and general management.

The issue is not:

“There should be no Wakalah fee.”

The issue is:

The Wakalah fee should be structured so that the operator is appropriately compensated while the remaining tabarru’ is still sufficient to support the PRF.

There must therefore be a balance between:

Operator sustainability

and

PRF sustainability.

11. Very Simple Example

Imagine Ahmad pays:

RM100

into a Takaful arrangement.

If:

RM20 → Wakalah fee

then:

RM80 → PRF

If the expected cost of Ahmad’s risk to the PRF is:

RM70

the RM80 allocation may be adequate.

But suppose:

RM40 → Wakalah fee

then:

RM60 → PRF

Expected claims cost remains:

RM70

Now:

RM60 < RM70

The total contribution is still RM100.

But the risk fund is underfunded.

That is exactly the problem.

Easy Way to Remember

There are two different questions:

Question 1

Is the total contribution sufficient?

For example:

RM1,000

Question 2

After deducting the Wakalah fee, is the remaining tabarru’ sufficient for the PRF?

For example:

RM1,000 − RM300 Wakalah fee = RM700 tabarru’

If expected PRF claims and obligations require RM800:

RM700 < RM800

Then the PRF may be inadequately funded even though the overall RM1,000 contribution initially appeared reasonable.

Simple Formula

Total Takaful Contribution − Wakalah Fee = Tabarru’ Available to PRF

(simplified; other allocations may apply)

Then ask:

Tabarru’ Available to PRF ≥ Expected Claims + Relevant PRF Costs/Provisions?

If YES → PRF is more likely to be adequately funded based on those assumptions.

If NO → there is a risk of underfunding and future deficit.

One-Sentence Summary

A Takaful contribution can be actuarially reasonable in total, but if the Wakalah fee deducted for the operator is too large, too little tabarru’ may remain in the Participants’ Risk Fund to meet expected claims and other obligations, creating a risk of PRF deficit and possible reliance on qard.

Takaful - What Is Surplus and How Is It Derived?

In Takaful, a surplus generally means the amount remaining in the Participants’ Risk Fund (PRF) after the fund has met its relevant obligations for the period.

The easiest way to think about it is:

Participants put money into the risk pool. Claims and other permitted costs come out. If enough money remains after the required obligations and provisions, the PRF may have a surplus.

1. Where Does the Surplus Come From?

First, participants make Takaful contributions.

Suppose 10,000 participants each contribute:

RM1,000

Total contributions:

RM10 million

However, depending on the Takaful model, not necessarily all RM10 million goes into the PRF. For example, part may be charged as a Wakalah fee, and in Family Takaful part may go into an individual investment fund.

Assume that after the relevant allocations:

RM8 million enters the PRF as tabarru’.

That RM8 million is available to support the collective risks of participants.

2. Claims Are Paid From the PRF

During the year, some participants suffer covered losses.

Suppose:

PRF contributions = RM8 million

Covered claims = RM4 million

After claims:

RM8m − RM4m = RM4m

But we should not immediately call RM4 million a surplus, because the PRF may still have other obligations.

3. Other Costs and Provisions Must Be Considered

The PRF may also have items such as:

Retakaful contributions/cost

claims-related expenses

required reserves or provisions

other permitted risk-fund expenses

depending on the applicable Takaful model and regulatory framework.

Suppose:

PRF contributions = RM8 million

Claims = RM4 million

Retakaful cost = RM1 million

Other relevant expenses/provisions = RM1 million

Then:

RM8m − RM4m − RM1m − RM1m = RM2 million

The remaining:

RM2 million

is the simplified underwriting surplus.

4. Simple Formula for Underwriting Surplus

For learning purposes:

Underwriting Surplus = PRF Income − Claims − Retakaful Costs − Relevant Expenses − Required Provisions/Reserves

So if:

PRF income = RM10m

Claims = RM6m

Retakaful = RM1m

Expenses/provisions = RM2m

Then:

RM10m − RM6m − RM1m − RM2m = RM1m surplus

5. Why Does a Surplus Arise?

A surplus can arise when the actual claims experience is better than expected or when the PRF otherwise has more income/resources than required for its obligations during the period.

For example, the operator might expect:

RM7 million of claims

but actual claims are only:

RM5 million

The lower claims experience can contribute to an underwriting surplus.

This is one reason careful underwriting and good risk pooling are important.

6. Example - Motor Takaful

Suppose 20,000 participants contribute to a Motor Takaful risk fund.

After the relevant allocations, the PRF receives:

RM20 million

During the year:

Claims = RM12 million

Retakaful cost = RM2 million

Other relevant expenses/provisions = RM3 million

Therefore:

RM20m − RM12m − RM2m − RM3m

= RM3 million underwriting surplus

So the PRF has RM3 million remaining after those obligations in this simplified example.

7. Does Surplus Mean Profit for the Takaful Operator?

No. This distinction is extremely important.

An underwriting surplus in the PRF is not automatically the profit of the Takaful operator or its shareholders.

Remember:

Participants’ Risk Fund ≠ Shareholder Fund

The PRF belongs to the mutual risk-sharing arrangement and bears the participants’ underwriting risk.

Therefore:

PRF underwriting surplus ≠ automatically shareholder profit

How the surplus is treated depends on the Takaful model, applicable regulations and contractual terms.

8. What Can Happen to the Surplus?

Depending on the particular Takaful structure and regulatory requirements, surplus may be:

retained in the PRF to strengthen the fund

distributed to eligible participants

used according to an approved surplus-sharing mechanism

or otherwise dealt with according to the applicable rules.

For example, suppose:

Underwriting surplus = RM5 million

The applicable arrangement might retain some or all of it in the PRF to strengthen the fund against future claims.

The important point is that the treatment should be clearly established and disclosed.

9. Why Retain Surplus in the PRF?

This connects directly to your previous question about maintaining sufficient capital.

Suppose the PRF generates:

Year 1 surplus = RM2m

Year 2 surplus = RM3m

Year 3 surplus = RM2m

If these amounts are appropriately retained, the PRF becomes financially stronger.

Accumulated amount:

RM2m + RM3m + RM2m = RM7 million

Now imagine Year 4 has unusually high claims.

The PRF has a stronger financial buffer to absorb those claims.

Therefore:

Retained Surplus → Stronger PRF → Greater Ability to Absorb Future Claims → Less Reliance on Qard

This is why accumulated surplus is important to the idea of mutuality.

10. What Happens If Claims Are Higher Than the Fund’s Resources?

Then instead of a surplus, the PRF may experience a deficit.

For example:

PRF income/resources for the calculation = RM10 million

Claims = RM9 million

Retakaful and other relevant costs/provisions = RM3 million

Therefore:

RM10m − RM9m − RM3m = −RM2 million

That is a:

RM2 million deficit

Where the applicable Takaful structure requires it, the shareholder/operator fund may provide qard to support the PRF.

So:

Positive balance → Surplus

Negative balance → Deficit

11. Surplus Is Not Simply “Unused Contributions”

This is another important distinction.

You should not think:

“Participants contributed RM10 million and claims were RM6 million, therefore surplus is automatically RM4 million.”

There may still be:

Retakaful costs

outstanding claim provisions

reserves

permitted expenses

and other obligations.

Only after the relevant obligations are properly accounted for can the underwriting surplus be determined.

12. What About Investment Income?

The PRF may also invest available money in Shari’ah-compliant investments.

Suppose the PRF invests part of its available assets and earns:

RM500,000 investment return

That can strengthen the financial position of the fund, subject to the applicable model.

However, for studying, it is useful to distinguish:

Underwriting surplus

from

Investment profit/return

They are related to the fund’s overall financial performance, but they arise from different activities.

Example

Suppose:

Tabarru’/risk-fund income = RM10m

Claims and underwriting-related obligations = RM8m

Underwriting surplus = RM2m

Separately, investments generate:

RM500,000

The RM500,000 is investment return, while the RM2 million is the underwriting surplus in this simplified example.

Do not automatically treat the two terms as identical.

13. Connection With Risk Pooling

Surplus also becomes easier to understand when you connect it with risk pooling.

Suppose:

10,000 participants → contribute to one PRF

The operator estimates how many claims are likely to occur.

But not everyone will suffer a loss during the year.

If the claims experience is favourable and the fund’s income exceeds its relevant claims, costs and provisions, a surplus may arise.

Therefore:

Many Participants → Common Risk Pool → Claims of Some Participants → Remaining Balance After Obligations = Potential Surplus

14. Very Simple Everyday Example

Imagine 100 friends create a mutual emergency fund.

Each contributes:

RM100

Total:

RM10,000

During the year:

Emergency payments = RM6,000

Administration = RM1,000

Required reserve = RM1,000

Remaining:

RM10,000 − RM6,000 − RM1,000 − RM1,000

= RM2,000

That RM2,000 illustrates the basic idea of a surplus.

The group might retain it to strengthen the fund for next year, depending on its agreed rules.

Easy Way to Remember

Think of the PRF like this:

MONEY IN

Tabarru’ contributions

• relevant PRF income

↓

MONEY OUT / PROVIDED FOR

Claims

• Retakaful
• permitted expenses
• required reserves/provisions

↓

WHAT REMAINS

= Surplus

If there is not enough:

= Deficit

Simple Formula

Surplus

PRF Income > PRF Claims + Costs + Required Provisions

= SURPLUS

Deficit

PRF Income < PRF Claims + Costs + Required Provisions

= DEFICIT

Most Important Distinction

Underwriting Surplus = belongs to the financial results of the Participants’ Risk Fund

Operator/Shareholder Profit = belongs to the operator/shareholder side according to the applicable business model

They are not the same thing.

One-Sentence Summary

A Takaful surplus is the amount remaining in the Participants’ Risk Fund after the relevant income has been used or provided for claims, Retakaful costs, permitted expenses, reserves and other obligations; it can strengthen the mutual risk fund and is not automatically profit belonging to the Takaful operator or shareholders.