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.