Takaful - The Role of Insurance in Finance

Insurance plays an important role in financing because banks and other institutional lenders usually require borrowers to maintain adequate insurance coverage on assets that are financed or used as security for a loan. This requirement helps protect both the lender and the borrower against financial losses that may arise if the insured property or business is damaged or destroyed.

For example, when a bank provides mortgage financing for the purchase or construction of a building, it may require the borrower to provide proof of insurance before the financing is approved or released. The purpose is to ensure that the property securing the financing is financially protected against specified risks.

Insurance is also particularly important for businesses that depend on external financing. If a financed building, factory, equipment, or other business asset is damaged by fire or another covered peril, the business may suffer significant financial loss and may no longer be able to generate enough income to meet its financing obligations.

The role of insurance in this situation is to reduce the risk of non-repayment by providing compensation for covered losses. The compensation can help repair or rebuild the damaged property, replace affected assets, or support the recovery of the business. This improves the likelihood that the borrower can continue operating and meeting its financial commitments.

The arrangement benefits both the financier and the borrower. The lender has greater protection over the outstanding financing because the insured asset has financial protection, while the borrower receives assistance to recover from the loss and restore the property or business.

In Islamic finance, takaful can provide the same protective function in a Shari’ah-compliant manner. Instead of relying on conventional insurance, the borrower may participate in an appropriate takaful scheme. Participants contribute to a common fund, and financial assistance is provided from the fund when a covered loss occurs.

Example – Financing of a Commercial Building

A business obtains RM2 million in financing from an Islamic bank to purchase a commercial building. As part of the financing arrangement, the bank requires the business to obtain property takaful protection for the building.

Who is covered?

The business owner or borrower is the takaful participant whose property is protected. The financing bank also has a financial interest in the property because it has provided financing secured against the building.

What is covered?

The takaful protection may cover the commercial building against specified risks such as fire, lightning, explosion, storm, flood, or other covered perils, depending on the terms and conditions of the takaful certificate.

Practical Example:

Suppose the commercial building is seriously damaged by a covered fire while the borrower still owes RM1.5 million to the bank. The takaful fund may provide compensation according to the terms and limits of the certificate. The compensation can help repair or rebuild the building and protect the financial interests of both the borrower and the bank.

The borrower benefits because the takaful compensation helps reduce the financial burden of rebuilding the damaged property and allows the business to resume operations more quickly.

The financier benefits because the takaful protection helps preserve the value of the asset supporting the financing and reduces the risk that the outstanding financing will not be repaid because of a major loss.

Therefore, insurance and takaful play an important role in finance by protecting financed assets, supporting the recovery of borrowers after unexpected losses, and reducing the financial risks faced by lending institutions.

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.