Takaful - Importance of Designing an Appropriate Retakaful Programme

As part of sound risk management, a Takaful operator should design a suitable Retakaful programme for its Takaful risk fund. The purpose is to make sure that the fund does not retain more risk than it can reasonably absorb.

Retakaful therefore helps the Takaful operator control the size of potential losses, protect the Participants’ Risk Fund, and increase its ability to underwrite larger or more volatile risks.

Takaful, like conventional insurance, depends heavily on the law of large numbers and probability. The basic idea is that when a sufficiently large number of similar risks are pooled together, the operator can estimate expected claims with greater accuracy.

For example, if a Takaful operator covers 100,000 motor vehicles, it may be able to estimate reasonably well how many accidents are likely to occur during the year based on past claims experience.

The larger and more diversified the group, the more predictable the overall claims experience tends to become.

However, the meaning of a “large enough group” depends on the type of risk being covered.

Some risks occur frequently but usually cause relatively small losses.

Other risks have a very low probability of happening, but if they do happen, the financial loss can be extremely large.

These low-frequency, high-severity risks require a much larger and stronger risk pool.

Example - Motor Risk

Suppose a Takaful operator covers:

100,000 cars

Assume around 5% are expected to make claims during the year.

That would mean approximately:

5,000 claims

Because there are many vehicles and many claims, the operator can use historical statistics and probability to estimate the likely total claims more reliably.

This is an example of a relatively large pool of similar risks.

Example - Large Industrial Risk

Now suppose the same Takaful operator wants to cover a petrochemical plant worth:

RM2 billion

The probability of a catastrophic fire may be very small.

Perhaps such a major event is extremely rare.

However, if it occurs, the claim could be:

RM500 million, RM1 billion, or even more

A single loss of this size could seriously weaken or even exhaust the Takaful risk pool.

Therefore, the operator may not be able to retain the entire risk on its own.

This is where Retakaful becomes important.

The Takaful operator can transfer or cede part of the exposure to a Retakaful risk pool.

For example:

Total industrial risk = RM2 billion

The Takaful operator may decide to retain:

RM200 million

and arrange Retakaful protection for:

RM1.8 billion

By doing this, the operator can participate in much larger risks without exposing its own risk pool to the full potential loss.

Why Low-Probability, High-Severity Risks Need Larger Pools

Suppose a Takaful operator covers only 10 large factories.

If one factory suffers a RM500 million loss, that one claim could dominate the entire portfolio.

The claims experience would therefore be highly volatile.

But if the operator participates in a much larger and more diversified portfolio of industrial risks, losses can be spread across more risks, geographical areas, industries, and participants.

This improves the effectiveness of risk pooling.

The key problem is:

Low probability does not mean low risk.

A loss may be unlikely to happen, but the consequences may be enormous.

For example:

Probability of loss = very low

but

Potential claim = RM1 billion

The Takaful operator must therefore consider both:

frequency of loss

and

severity of loss

How Retakaful Increases Takaful Capacity

Without Retakaful, a Takaful operator might have to reject a very large risk because its own Participants’ Risk Fund is not strong enough to absorb the potential claim.

With Retakaful, the operator can retain only the portion it is comfortable with and pass part of the exposure to the Retakaful provider.

Therefore:

Retakaful increases underwriting capacity.

Clear Example

Suppose the Takaful operator can safely retain only:

RM50 million per major industrial risk

A company requests Takaful protection of:

RM300 million

Without Retakaful:

The operator may have to reject the risk because RM300 million exceeds its capacity.

With Retakaful:

Takaful retains RM50 million

Retakaful accepts RM250 million

The Takaful operator can now provide the RM300 million protection while limiting the amount retained by its own risk pool.

What an Appropriate Retakaful Programme Should Consider

A suitable Retakaful programme should take into account factors such as the size of the Takaful risk fund, the types of risks covered, expected claim frequency, potential claim severity, concentration of risks, geographical exposure, catastrophe exposure, solvency needs, and the operator’s desired retention level.

The operator must therefore decide:

How much risk can the Takaful fund safely keep?

and

How much should be ceded to Retakaful?

Simple Idea

Takaful works best when many risks are pooled together.

But some risks are:

rare + extremely expensive

and these may be too large for one Takaful risk pool to absorb safely.

Retakaful allows part of these risks to be shared with another risk pool.

Easy Formula

**Large Number of Similar Risks

• Diversification
• Probability Analysis
• = More Predictable Claims**

But:

Low-Frequency + High-Severity Risk

= Greater Volatility and Larger Capital Requirement

Therefore:

Takaful Risk Pool + Appropriate Retakaful Programme

= Greater Capacity + Better Stability + Stronger Risk Management

Easy Way to Remember

Takaful pools the risks of participants.

Retakaful helps pool the risks of Takaful operators.

So, when the original Takaful pool is not large or strong enough to safely absorb very large risks, Retakaful provides additional capacity and protection.