Takaful - Insurance Models There are two main corporate models used to provide insurance services: 1. Mutual Insurer A mutual insurer is owned collectively by its policyholders. The policyholders are both: Customers / insured persons Owners of the insurance entity Each policyholder places their individual risk into a common pool. The risks of all policyholders are pooled together. As owners, the policyholders collectively bear the pooled risks. Any remaining financial interest or surplus ultimately belongs to the policyholders. Simple Example 1,000 people join a mutual insurance company. Each person pays a premium into the common pool. If some members suffer insured losses, claims are paid from that pool. Because the policyholders collectively own the insurer, they ultimately share in the financial results of the organisation. Simple Idea Policyholders = Insured persons + Owners

2. Stock Insurance Company A stock insurance company is owned by shareholders or investors. The people who buy insurance are normally customers, not owners of the company. Shareholders provide capital to support the insurance business. The insurer collects premiums from policyholders and accepts the risks covered under the insurance contracts. Claims are paid when covered insured events occur. Shareholders are entitled to the profits generated by the insurance company. Insurance Fund In some countries, regulators require the insurer to maintain an insurance fund separately from the shareholders’ fund. The insurance fund may therefore be legally or financially separated from the shareholders’ fund. However, the insurance company itself is still ultimately owned by the shareholders. Simple Idea Policyholders = Customers Shareholders = Owners

Why Stock Insurance Companies Developed Mutual insurers played an important role in the early development of modern insurance. Over time, investors recognised that insurance could also become a profitable commercial activity. Insurance businesses therefore increasingly developed into stock companies financed by shareholder capital. Another important reason was the increasing size of potential insured losses. As economies and businesses grew, insurers had to be able to cover increasingly large claims. Modern insurance companies therefore require substantial capital to strengthen their ability to meet these obligations.

Role of Shareholder Capital Shareholders contribute money known as shareholder capital to the insurance company. This capital exists in addition to the premiums collected from policyholders. It provides additional financial strength to the insurer. Shareholder capital can be used to: Support the establishment of the insurance company Finance operating activities Meet regulatory capital requirements Maintain liquidity Invest in permitted assets Absorb unexpected losses Provide an additional financial cushion if claims are higher than expected Shareholder capital therefore increases the probability that the insurance company will be able to pay valid claims. Simple Relationship Premiums + Shareholder Capital → Greater Financial Capacity to Pay Claims Example Shareholders invest RM50 million in an insurance company. Policyholders later pay RM100 million in premiums. The insurer now has financial resources from: Shareholder capital Premium income The RM50 million shareholder capital does not necessarily remain unused. Part may be: Invested Kept in cash or liquid assets Used to support operations Held as financial capital to absorb unexpected losses

Underwriting Process Before providing insurance coverage, the insurer carries out underwriting. Underwriting is the process of evaluating the risk before accepting it. During Underwriting, the Insurer: Examines the risk Estimates the probability that a loss may occur Estimates the possible size of the loss Decides whether to accept the risk Determines the appropriate premium Determines the terms and conditions of the insurance coverage Example Ahmad wants to insure his car. Before providing coverage, the insurer evaluates factors such as: Type of car Value of the car Age of the vehicle Ahmad’s driving history Probability of an accident Expected cost of possible claims Based on these factors, the insurer determines the premium Ahmad must pay. Simple Process Insurer evaluates risk → Sets premium → Accepts risk → Provides coverage → Pays claim if a covered event occurs

How a Stock Insurance Company Makes Profit Shareholders invest their capital because they expect to earn a return on their investment. An insurance company can generate profit from several different sources. These include: Underwriting surplus Expense profit Investment margin

1. Underwriting Surplus Policyholders pay premiums to obtain insurance coverage. The insurer pools these premiums. Claims are paid when covered insured events occur. If the premium income available is greater than the claims and related insurance costs, an underwriting surplus may arise. Simple Relationship Premium Income > Claims and Related Costs → Underwriting Surplus Example Suppose: Premium income = RM100 million Claims and related costs = RM80 million Therefore: RM100m − RM80m = RM20m underwriting surplus This surplus contributes to the overall financial result of the stock insurance company. Because shareholders own the company, they ultimately benefit from the company’s profits, subject to reserves, regulatory requirements, taxes, retained earnings and dividend decisions.

2. Expense Profit Part of the premium charged to policyholders is calculated to cover the insurer’s expected operating expenses. These may include: Employee salaries Administrative costs Office costs Technology systems Distribution costs Other operating expenses If the insurer’s actual expenses are lower than the amount allowed for expenses in the premiums, an expense profit may arise. Example Amount provided for expected expenses = RM10 million Actual expenses = RM8 million Therefore: RM10m − RM8m = RM2m expense profit

3. Investment Margin Insurance premiums are generally received before claims are paid. Therefore, premium funds do not necessarily remain static while the insurer waits for claims. Part of the premium funds may be invested while they are not immediately needed. The insurer must still keep sufficient funds available to: Pay claims Cover operating expenses Maintain reserves Maintain liquidity Meet regulatory requirements Example The insurer receives premiums today. Some claims may only arise several months or years later. During this period, the insurer may invest part of the available premium funds. The investments may generate a return. This return contributes to the insurer’s financial results. Simple Relationship Premiums Received → Part Kept Available + Part Invested → Investment Income Earned

Can Premiums Be Invested? Yes, premium funds can also be invested. Premiums do not simply sit untouched until a claim occurs. The insurer usually receives premiums before claims need to be paid. This creates an opportunity to invest part of the available funds. Example Suppose an insurer collects RM100 million in premiums. The insurer may manage the money approximately as follows: RM25 million Kept as cash or highly liquid assets Available to pay near-term claims RM60 million Invested in permitted assets Generates investment income RM15 million Used for operating expenses and other obligations Therefore: Premium Received → Part Kept Available → Part Invested → Claims and Expenses Paid as Required

Can Shareholder Capital Also Be Invested? Yes, part of the shareholder capital may also be invested. However, shareholder capital does not have to be invested entirely. It supports the overall insurance business. Example Suppose shareholders provide RM50 million. The insurer may use it approximately as follows: RM30 million Invested in permitted assets RM10 million Kept as cash or liquid assets RM5 million Used for initial operating or setup costs RM5 million Retained as part of the company’s financial cushion Therefore: Shareholder Capital → Operations + Liquidity + Investments + Financial Cushion It should not be understood as: Shareholder Capital → Investment Only

Two Main Sources of Funds in a Stock Insurance Company Shareholder Capital Comes from the shareholders or owners. Represents their investment in the insurance company. Supports the establishment and operation of the company. Provides additional financial backing. Helps absorb unexpected losses. May be invested. Helps the company meet capital and regulatory requirements. Policyholder Premiums Come from customers purchasing insurance coverage. Mainly support: Claims Insurance expenses Reserves Other insurance obligations Part of the premiums may also be invested until needed. Important Difference Shareholder Capital Comes from owners Provides financial backing to the company Can absorb losses May generate investment income Premiums Come from policyholders Are paid in exchange for insurance protection Mainly support claims and related expenses May also generate investment income while waiting to be used

Combined Example Suppose: Shareholders invest = RM50 million Policyholders pay premiums = RM100 million The insurer may decide: RM30 million of shareholder capital is invested RM60 million of premium funds is invested Therefore: RM30m + RM60m = RM90m invested Suppose the investments produce a return of RM4 million. The RM4 million becomes part of the insurer’s investment income. This investment income contributes to the company’s overall financial performance. Therefore, investment income can arise from: Invested Shareholder Funds + Invested Premium Funds

Easy Comparison Mutual Insurer Owned by policyholders. Policyholders are both: Customers Owners Policyholders collectively participate in the mutual insurance arrangement. Risks are pooled among the members. The residual financial interest ultimately belongs to the policyholder-members. Any surplus ultimately benefits the policyholder-members. There are no outside shareholders expecting a return on shareholder capital. The main focus is mutual protection. Simple Idea Policyholders insure together and own the company together.

Stock Insurance Company Owned by shareholders. Policyholders are mainly customers. Shareholders provide capital to support the insurer. The insurer accepts and manages the policyholders’ insured risks. The residual financial interest belongs to the shareholders. Profits ultimately benefit shareholders. Shareholders expect a return on the capital they have invested. The company operates on a commercial basis. Simple Idea Customers buy insurance, while shareholders own the company and expect profits.

Easy Way to Remember Mutual Insurance Policyholders = Customers + Owners They pay premiums. Their risks are pooled. They collectively own the mutual insurer. Surplus ultimately benefits them. Stock Insurance Policyholders = Customers Shareholders = Owners Policyholders pay premiums for protection. Shareholders provide capital to support the company. Both premium funds and shareholder funds may be invested. Shareholders ultimately benefit from the company’s profits.