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.