Takaful – Methods of Retakaful

Case Scenario

A Takaful operator has developed a large portfolio consisting of motor, property, medical, and commercial risks. Management is concerned that a major catastrophe could generate claims beyond the capacity of the Takaful Fund. The operator therefore decides to obtain Retakaful protection.

Management considers two main approaches. For certain large and unusual individual risks, it uses Facultative Retakaful, where each risk can be considered separately. For its broader portfolio of recurring risks, it uses Treaty Retakaful, where risks falling within agreed treaty conditions are covered collectively.

The operator must also decide how losses will be shared. Under a proportional arrangement, the Takaful and Retakaful operators share risks and losses according to agreed proportions. Under a non-proportional arrangement, the Takaful operator absorbs losses up to an agreed deductible or retention level, while the Retakaful arrangement responds to losses above that level, subject to an agreed upper limit.

This illustrates how different Retakaful methods allow risks to be divided and distributed according to the financial needs of the Takaful operator.

Key Notes

Purpose of Retakaful Methods

Different Retakaful methods are designed to:

• Divide large risks into manageable portions.
• Share claims between Takaful and Retakaful arrangements.
• Protect Takaful Funds against unusually large losses.
• Increase underwriting capacity.
• Reduce the financial effect of catastrophic events.
• Support the long-term stability of the Takaful industry.

Risk Distribution and Retrocession

A Retakaful operator may itself pass part of the risks it has accepted to another reinsurer or Retakaful provider.

This process is known as retrocession.

Therefore, risk may be distributed through several levels:

• Original participant → Takaful operator.
• Takaful operator → Retakaful arrangement.
• Retakaful operator → another provider through retrocession.

This creates additional capacity for absorbing major losses.

Two Main Methods of Retakaful

Retakaful has two main methods:

1. Facultative Retakaful

• Also known as the selective method.
• Individual risks are separately considered.

2. Treaty Retakaful

• Also known as the comprehensive method.
• A portfolio or category of qualifying risks is covered under an agreement.

Both methods can be structured as either:

• Proportional, or
• Non-proportional.

Methods of Retakaful – Diagram in Note Form

A. Facultative Retakaful

Facultative Retakaful can be:

• Proportional Facultative Retakaful
• Non-Proportional Facultative Retakaful

B. Treaty Retakaful

Treaty Retakaful can be:

Proportional Treaty

• Quota Share
• Surplus

Non-Proportional Treaty

• Excess of Loss
• Stop Loss

1. Proportional Retakaful

Under proportional Retakaful:

• Risk is shared according to an agreed proportion.
• Contributions are allocated proportionally.
• Claims or losses are also shared proportionally.
• The proportion accepted determines the corresponding responsibility for losses.

Example

Suppose:

• Takaful operator retains = 70%
• Retakaful arrangement accepts = 30%
• Covered claim = US$100,000

Therefore:

• Takaful operator bears = US$70,000
• Retakaful arrangement bears = US$30,000

Types of Proportional Treaty Retakaful

A. Quota Share

Under Quota Share:

• A fixed percentage of the portfolio is shared.
• Contributions are shared according to the same agreed proportion.
• Losses are also shared according to that proportion.

Example

If the agreed quota is 60:40:

• Takaful operator retains 60%.
• Retakaful arrangement accepts 40%.
• Contributions and covered losses are allocated according to that agreed proportion.

B. Surplus

Under the Surplus method:

• The Takaful operator determines how much risk it is prepared to retain.
• The amount exceeding its retention may be placed with the Retakaful arrangement, subject to agreed treaty capacity.

This allows the Takaful operator to retain more of smaller risks while obtaining additional protection for larger risks.

2. Non-Proportional Retakaful

Under non-proportional Retakaful:

• Losses are not divided according to a fixed percentage.
• The Takaful operator bears losses up to an agreed amount.
• This amount is commonly called the retention or deductible.
• The Retakaful arrangement responds to losses exceeding that amount.
• Protection continues only up to the agreed upper limit.

The contribution charged for this protection is based on the expected exposure of the overall covered portfolio rather than simply being a fixed proportion of the original contribution.

Types of Non-Proportional Treaty Retakaful

A. Excess of Loss

Under Excess of Loss:

• The Takaful operator absorbs losses up to the agreed retention.
• The Retakaful arrangement covers the portion above that retention, subject to the contractual limit.

Example

Suppose:

• Takaful operator’s retention = US$1 million
• Retakaful protection = next US$4 million
• Covered loss = US$3 million

Therefore:

• Takaful operator bears = US$1 million
• Retakaful arrangement bears = US$2 million

B. Stop Loss

Stop Loss protection generally responds when the aggregate losses of a portfolio over an agreed period exceed a predetermined level.

It therefore helps protect the Takaful Fund against an unusually high overall level of claims.

Proportional vs Non-Proportional Retakaful

Proportional

• Risks and losses are shared according to agreed proportions.
• Contribution allocation follows the agreed sharing arrangement.
• Examples include:
• Quota Share
• Surplus

Non-Proportional

• No fixed percentage sharing of every loss.
• Takaful operator bears losses up to an agreed retention.
• Retakaful responds above that level, subject to a limit.
• Examples include:
• Excess of Loss
• Stop Loss

Key Point

Retakaful can be arranged through Facultative or Treaty methods, and either method may be proportional or non-proportional. Under proportional Retakaful, risks and losses are shared according to agreed proportions, whereas under non-proportional Retakaful, the Takaful operator bears losses up to an agreed retention and Retakaful protection applies above that level subject to agreed limits.

Questions and Answers

Question 1

What are the two main methods of Retakaful?

Answer:

The two main methods are Facultative Retakaful and Treaty Retakaful.

Solution:

Select the method according to whether protection is required for individual risks or a broader portfolio.

Question 2

What is another name for Facultative Retakaful?

Answer:

It is also called the selective method.

Solution:

Use it when individual risks require separate consideration.

Question 3

What is another name for Treaty Retakaful?

Answer:

It is also called the comprehensive method.

Solution:

Use Treaty Retakaful when protection is required for qualifying risks across a portfolio.

Question 4

What are the two basic ways of structuring Facultative and Treaty Retakaful?

Answer:

They can be structured as proportional or non-proportional.

Solution:

Choose the structure according to the operator’s desired level of risk retention.

Question 5

How does proportional Retakaful work?

Answer:

The Takaful and Retakaful arrangements share risks and covered losses according to agreed proportions.

Solution:

Clearly establish the percentage accepted by each party.

Question 6

What are the main proportional Treaty Retakaful methods?

Answer:

They are Quota Share and Surplus.

Solution:

Select the appropriate proportional structure according to the portfolio and retention strategy.

Question 7

How does non-proportional Retakaful work?

Answer:

The Takaful operator bears losses up to an agreed retention, after which the Retakaful arrangement covers losses up to an agreed upper limit.

Solution:

Set an appropriate retention based on the Takaful Fund’s financial capacity.

Question 8

What are the main non-proportional Treaty Retakaful methods?

Answer:

They are Excess of Loss and Stop Loss.

Solution:

Use the method that best matches the type of loss exposure being protected.

Question 9

What is retrocession?

Answer:

Retrocession occurs when a Retakaful operator passes some of the risks it has accepted to another provider.

Solution:

Use retrocession to further distribute large exposures and strengthen risk-bearing capacity.

Question 10

Why are different Retakaful methods necessary?

Answer:

Different risks require different approaches to risk sharing, retention, and financial protection.

Solution:

Match the Retakaful method to the size, frequency, and potential severity of the underlying risks.

Practical Application

A Takaful operator should analyse its portfolio, capital position, claims experience, and risk appetite before selecting a Retakaful method. Large individual risks may be suitable for Facultative Retakaful, while portfolios containing many similar risks may benefit from Treaty Retakaful. Proportional arrangements can be used when the operator wants risks and losses shared according to agreed proportions, whereas non-proportional arrangements can provide protection against losses exceeding specified retention levels.

Critical Analysis

The availability of several Retakaful methods enables Takaful operators to construct protection according to the nature of their portfolios. Facultative arrangements provide greater individual risk selection, while treaty arrangements offer efficiency for broader portfolios. Similarly, proportional methods create direct sharing of risks and losses, whereas non-proportional methods primarily protect against losses that exceed predetermined levels.

The effectiveness of these arrangements depends on appropriate pricing, underwriting standards, retention levels, portfolio analysis, and claims management. Retakaful and retrocession can also spread exceptionally large exposures across several institutions, helping the Islamic insurance industry absorb catastrophic losses without placing excessive pressure on a single Takaful Fund.

Conclusion

Retakaful uses different methods to distribute risks and protect Takaful operators against significant losses. The two principal methods are Facultative and Treaty Retakaful, and both may operate on either a proportional or non-proportional basis. Proportional Treaty Retakaful includes Quota Share and Surplus, while non-proportional Treaty Retakaful includes Excess of Loss and Stop Loss. Understanding these methods allows Takaful operators to select suitable protection, manage their financial exposure, and maintain the stability of participants’ funds.