Takaful - Higher Cost of Retakaful Compared with Reinsurance

• In practice, Retakaful contributions may be somewhat higher than equivalent conventional reinsurance premiums.
• However, the difference is generally not necessarily very large.
• A higher Retakaful contribution by itself is not automatically a sufficient reason to invoke necessity (darurah) and choose conventional reinsurance instead.
• The higher cost may arise because of several structural and market-related factors.

1. Why Retakaful Contributions May Be Higher

Smaller Risk Pool

• Retakaful generally operates with a much smaller volume of business than conventional reinsurance.
• A smaller pool means:
• Fewer risks are being shared
• Less diversification
• Greater volatility of claims
• Higher impact from individual large claims
• The Retakaful operator may therefore need to charge higher contributions to maintain sufficient financial strength.

Example

Suppose:

• Conventional reinsurer pools risks from 1,000 insurers worldwide.
• Retakaful operator pools risks from only 100 Takaful operators.

If both face a RM100 million catastrophe claim:

• The large conventional pool can spread the loss across much more business.
• The smaller Retakaful pool feels a much greater financial impact.

Therefore:

Smaller Retakaful pool → Greater volatility → Potentially higher Retakaful contribution

2. Product Design Can Increase the Cost

• Retakaful products may be structured differently from conventional reinsurance.
• Certain features can increase the contribution required.
• One example is surplus sharing.

Example

• Takaful Operator A pays RM10 million in Retakaful contributions.
• At the end of the year, the Retakaful fund performs well and generates a surplus.
• Under the agreed arrangement, part of that surplus may be distributed or allocated according to the Retakaful model.
• Because such benefits form part of the product design, the initial contribution may be somewhat higher.

Simple Idea

Additional features in Retakaful → May increase contribution

3. Higher Cost Alone Does Not Automatically Create Necessity

• Shari’ah may permit conventional reinsurance in exceptional circumstances where suitable Retakaful is genuinely unavailable or inadequate.
• However, the fact that Retakaful is merely slightly more expensive does not automatically justify using conventional reinsurance.
• The Takaful operator should normally consider the Shari’ah-compliant Retakaful option first.

Example

Suppose:

• Retakaful contribution = RM10.5 million
• Conventional reinsurance premium = RM10 million

Difference:

RM500,000

• The conventional option is cheaper.
• However, the small price difference alone would not necessarily amount to a situation of necessity.

Simple Idea

Cheaper conventional reinsurance ≠ Automatically a necessity

4. Financial Strength Rating of the Retakaful Provider

• Cost is not the only consideration.
• A Takaful operator must also consider the financial strength rating of the Retakaful provider.
• Ratings are usually provided by recognised rating agencies.
• They indicate the provider’s ability to meet its financial obligations and pay claims.

Why Is Rating Important?

• Retakaful is often used for very large risks.
• The Takaful operator must have confidence that the Retakaful provider will be able to pay when a major claim occurs.

Example

A Takaful operator wants to protect a major aviation risk.

It has two potential Retakaful providers:

• Provider A → Strong financial rating
• Provider B → Weak financial rating

Even if Provider B charges a lower contribution, the Takaful operator may reject it because the provider may not meet its required financial-strength standards.

Simple Idea

Low price is not enough → Retakaful provider must also be financially strong

5. What Is Risk Appetite?

• Risk appetite refers to the amount and type of risk an organisation is willing to accept.
• A Takaful operator may establish minimum requirements for the Retakaful companies with which it is willing to deal.
• One requirement may be a minimum financial-strength rating.

Example

Suppose a Takaful operator has a policy stating:

“We will only place major risks with Retakaful providers rated A or above.”

Two providers are available:

• Retakaful Company A → Rating A
• Retakaful Company B → Rating BBB

Even if Company B is cheaper, the Takaful operator may choose Company A because Company B falls outside its risk appetite.

Simple Idea

Risk appetite = How much risk the Takaful operator is willing to tolerate

6. Why a Weak Rating Could Lead to Conventional Reinsurance

• Historically, there may have been situations where:
• Retakaful was available
• But the available Retakaful operators did not have sufficiently strong ratings
• A Takaful operator covering a very large risk might therefore have been unwilling or unable to place the risk with them.
• It could then consider a highly rated conventional reinsurer, subject to the applicable Shari’ah rules on necessity or need.

Example

A Takaful operator needs:

RM500 million of protection

Available Retakaful provider:

• Capacity = RM500 million
• Rating = below the Takaful operator’s minimum requirement

Conventional reinsurer:

• Capacity = RM500 million
• Strong international rating

The issue is therefore not simply price.

It is:

“Will the provider still be financially capable of paying RM500 million if a major loss occurs?”

7. Retakaful Windows Have Reduced the Rating Problem

• The text explains that this rating problem should now be less significant.
• Many large international conventional reinsurers have established Retakaful windows.
• These windows offer Shari’ah-compliant Retakaful services while benefiting from the:
• Financial strength
• Expertise
• Capital resources
• Global network
• Reputation

of the larger reinsurance group.

Example

• A major global reinsurer has a strong international credit rating.
• It establishes a separate Retakaful window.
• A Takaful operator can obtain:
• Shari’ah-compliant Retakaful protection
• From a financially strong international group

Simple Idea

Large reinsurer + Retakaful window = Shari’ah-compliant protection backed by stronger financial capacity

Overall Reasons Retakaful May Cost More

Retakaful contributions may be higher because of:

• Smaller volume of business
• Smaller risk pool
• Less diversification
• Greater claim volatility
• Product design
• Surplus-sharing arrangements
• Higher operating costs
• Limited economies of scale

However:

Higher Retakaful cost alone does not automatically justify choosing conventional reinsurance.

Easy Way to Remember

Cost Issue

Smaller Retakaful pool → Higher risk per operator → Potentially higher contribution

Rating Issue

Retakaful provider must be financially strong enough to pay large claims

Risk Appetite

Takaful operator decides the minimum level of financial risk it is willing to accept from its Retakaful providers

Modern Development

Large international reinsurers → Establish Retakaful windows → Strong ratings + Shari’ah-compliant Retakaful capacity

Simple Formula

Retakaful Selection = Shari’ah Compliance + Price + Financial Rating + Capacity + Risk Appetite

Not simply:

Choose whichever option is cheapest