Takaful - Regulation and Supervision of Takaful

Regulation and supervision of Takaful aim to ensure that Takaful operators understand the risks they are managing, maintain sufficient resources to manage those risks, treat participants fairly, remain financially sound, and operate in accordance with Shari’ah requirements.

The central regulatory principle is:

First identify and allocate the risks → then ensure sufficient resources are available to manage those risks.

Importantly, resources do not mean capital alone. They also include competent people, appropriate IT systems, governance and other operational capabilities.

1. First Principle - Determine Where the Risks Are

Before deciding how much capital or other resources are required, the regulator must understand:

What risks exist, and who bears those risks?

This is particularly important in Takaful because different risks may be borne by different parties or funds.

For example:

Participants’ Risk Fund (PRF) bears the participants’ underwriting risk.

The Takaful operator manages the Takaful operation and faces operational, management and other business risks.

The shareholder/operator fund provides the operator’s financial resources and may support the PRF through qard where applicable.

Therefore, regulation should recognise the fund structure and allocation of risks rather than treating every risk as if it belonged to the same party.

2. Example - Allocation of Underwriting Risk

Suppose:

PRF underwriting income/resources = RM20 million

Relevant claims and obligations = RM25 million

Therefore:

RM20m − RM25m = −RM5m

The PRF has:

RM5 million underwriting deficit

The underwriting risk belongs primarily to the participants collectively through the PRF, rather than automatically becoming an underwriting loss of the operator’s shareholders.

The regulator therefore needs to determine:

Who bears the risk?

before deciding:

What resources are required and where should those resources be maintained?

3. Regulation Is Not Only About Capital

When we hear:

“The Takaful operator must have sufficient resources.”

we might immediately think of:

Money or capital.

But regulatory resources are much broader.

They include:

Financial capital

Competent and appropriately trained employees

Actuaries

Underwriters

Claims personnel

Risk-management personnel

Shari’ah expertise

IT systems

Data and cybersecurity infrastructure

and

appropriate governance systems

Therefore:

Financial strength without operational capability is not sufficient.

4. Why Are Human Resources Important?

Suppose a Takaful operator has:

RM500 million capital

but its underwriters are poorly trained.

They repeatedly accept high-risk participants at inadequate contributions.

This could result in:

Poor underwriting

↓

Inadequate pricing

↓

Excessive claims

↓

PRF deficits

↓

Financial pressure

Therefore, having a large amount of capital does not compensate indefinitely for poor management.

A Takaful operation needs both:

Financial Resources + Competent Human Resources

5. Why Are IT Systems Important?

Modern Takaful operators may manage thousands or millions of:

participants

contributions

claims

certificates

investments

and

financial transactions.

Suppose an operator has adequate capital but a poor IT system that cannot accurately track:

participant contributions

claims

PRF balances

or

investment allocations.

This creates significant operational risk.

Therefore:

Capital + Skilled People + Reliable Systems = Stronger Risk Management

6. Risk-Based Capital

An important regulatory approach is Risk-Based Capital (RBC).

The basic principle is:

The amount of capital required should reflect the amount and nature of risk being taken.

Therefore:

Higher risk → Generally higher required capital

Lower risk → Generally lower required capital

This is more meaningful than requiring every Takaful operator to maintain exactly the same amount of capital regardless of its risk profile.

7. Simple Risk-Based Capital Example

Suppose:

Takaful Operator A

Required capital = RM100 million

Available capital = RM180 million

Takaful Operator B

Required capital = RM300 million

Available capital = RM320 million

At first, Operator B appears stronger because:

RM320m > RM180m

But this is misleading because Operator B also carries much greater risk.

We therefore compare:

Available Capital ÷ Required Capital

8. Risk-Based Capital Ratio

A simplified formula is:

Capital Adequacy Ratio = Available Capital ÷ Required Capital × 100%

For Operator A:

RM180m ÷ RM100m × 100 = 180%

For Operator B:

RM320m ÷ RM300m × 100 ≈ 107%

Therefore, even though Operator B has more capital in absolute terms, its capital position relative to its risks is much tighter.

This is the purpose of a risk-based approach.

Do not look only at how much capital exists. Compare the available capital with the amount of capital required for the risks being taken.

9. Why Does the Regulator Monitor This Ratio?

Suppose an operator’s capital ratio changes:

Year 1 = 200%

Year 2 = 175%

Year 3 = 145%

Year 4 = 120%

The ratio is progressively deteriorating.

The regulator should not necessarily wait until:

Capital = RM0

or until the operator becomes unable to meet its obligations.

Instead, if the ratio falls to a predetermined regulatory intervention level, this acts as an early warning.

The regulator may then take appropriate supervisory action.

10. Why Is Early Regulatory Intervention Important?

The objective of risk-based supervision is to detect financial weakness before it becomes a severe solvency problem.

The process is:

Risk increases

↓

Required capital increases or available capital falls

↓

Capital ratio decreases

↓

Predetermined regulatory level reached

↓

Regulatory intervention

↓

Corrective action

Therefore:

The regulator tries to identify problems early rather than waiting until the Takaful operation fails.

11. Regulation Also Protects Participants

Regulation is not only concerned with financial solvency.

It also aims to ensure that participants are treated fairly.

This can include:

appropriate product design

clear disclosure

fair pricing

proper sales practices

protection against mis-selling

fair claims handling

and

management of conflicts of interest.

This directly connects with the earlier issue of product mis-selling risk.

12. What Happens If the Operator Treats Participants Unfairly?

The regulator may impose appropriate supervisory measures or sanctions under the applicable regulatory framework.

For example, suppose an operator systematically allows intermediaries to tell participants:

“This Family Takaful product guarantees a particular investment return.”

But the return is actually non-guaranteed.

Participants may purchase the product based on incorrect information.

This creates:

Misrepresentation

↓

Participant misunderstanding

↓

Mis-selling

↓

Unfair customer treatment

The regulator may therefore take action against the operator.

13. But Regulation Can Become Excessive

There needs to be a balance.

Too little regulation can result in:

mis-selling

poor underwriting

inadequate capital

unfair fees

weak governance

and potentially:

financial failure.

However, excessively restrictive regulation can create another problem:

It may stifle innovation.

This means Takaful operators may find it difficult or uneconomic to develop new products, technologies, distribution methods or business models.

14. Example - Excessive Regulation and Innovation

Suppose a Takaful operator wants to introduce an innovative low-cost digital Takaful product.

The objective is to allow participants to:

join online

make contributions digitally

submit claims electronically

and

receive faster service.

But suppose the regulatory framework contains extremely rigid requirements designed only for traditional branch-based operations.

The cost of complying with those requirements may make the new digital product economically unattractive.

Therefore:

Excessive Regulation

↓

Higher Compliance Burden

↓

Reduced Innovation

The regulator therefore needs to achieve:

Participant Protection + Financial Stability + Room for Appropriate Innovation

15. Fair Treatment Does Not Mean Charging the Lowest Fee

This is a particularly important point.

The requirement to:

“Treat participants fairly”

should not automatically be interpreted as:

“The Takaful operator must charge the lowest possible fee.”

The operator needs sufficient income to operate sustainably.

The Wakalah fee may support activities such as:

staff salaries

underwriting

claims administration

IT systems

distribution

regulatory compliance

Shari’ah governance

and other operating expenses.

Therefore:

A low fee is not automatically a fair fee.

The appropriate question is whether the fee is reasonable, transparent and consistent with the services and responsibilities undertaken by the operator.

16. Example - Lowest Fee Is Not Necessarily Better

Suppose:

Operator A

Wakalah fee = RM200

This allows the operator to maintain:

competent staff

good claims service

strong IT systems

proper underwriting

and

appropriate governance.

Operator B

Wakalah fee = RM80

The fee appears more attractive to participants.

But suppose RM80 is insufficient to maintain proper operations.

As a result:

service deteriorates

staff quality falls

IT investment is inadequate

and

risk management weakens.

Therefore:

Fair treatment should focus on value and appropriate treatment, not simply the lowest possible fee.

17. Supply Side and Demand Side

A sustainable Takaful industry requires appropriate incentives on both the supply side and demand side.

Supply Side - Takaful Operator

The operator supplies the Takaful service.

It expects to earn a:

Reasonable return on the capital and resources employed.

Investors provide:

capital

technology

management expertise

and other resources.

If the business cannot generate a reasonable sustainable return, investors may become unwilling to provide those resources.

Demand Side - Participants

Participants demand Takaful products.

They expect to receive:

appropriate protection

reasonable costs

and, where applicable,

savings and investment benefits.

Therefore:

Operator wants reasonable return

while:

Participant wants cost-effective protection and savings

A successful Takaful structure should try to satisfy both objectives sustainably.

18. The Interests Must Be Balanced

Suppose the operator charges extremely high fees.

Then:

Operator return ↑

but:

Participant value ↓

Participants may stop purchasing the product.

Now consider the opposite situation.

Suppose fees are forced to extremely low levels.

Then:

Participant cost may initially ↓

but:

Operator sustainability ↓

The operator may eventually reduce:

staff

technology

service quality

or

product innovation.

Therefore:

Reasonable Operator Return + Cost-Effective Participant Protection = More Sustainable Takaful

This connects directly with the principle of alignment of stakeholder interests.

19. A Holistic Approach to Takaful

A holistic approach means looking at the entire Takaful system rather than concentrating on only one component.

The system includes:

Participants

Participants’ Risk Fund

Takaful operator

Shareholders

Management

Intermediaries

Shari’ah governance

Retakaful

Investments

Technology

and

Regulators.

For example, simply forcing contributions to be very low may appear beneficial to participants.

But if:

Contribution too low

↓

Insufficient tabarru’

↓

PRF deficit

↓

Greater qard dependence

↓

Financial weakness

then the low contribution was not necessarily beneficial in the long term.

Therefore:

Takaful regulation should consider the entire system and its long-term sustainability.

20. International Association of Insurance Supervisors (IAIS)

Insurance regulators can look to the International Association of Insurance Supervisors (IAIS) for an internationally recognised framework for insurance supervision.

An important part of this framework is the:

Insurance Core Principles (ICPs)

These provide principles, standards and guidance relating to the regulation and supervision of the insurance sector.

The broad idea is:

IAIS provides an internationally recognised foundation that regulators can consider when developing their insurance supervisory frameworks.

21. What Are Insurance Core Principles?

The Insurance Core Principles (ICPs) provide a broad international framework covering important areas of insurance regulation and supervision.

They help regulators establish appropriate standards concerning matters such as insurance supervision and risk management.

The important concept to remember is:

IAIS → General international insurance supervisory framework

However, Takaful has additional structural and Shari’ah considerations.

Therefore, conventional insurance supervisory principles alone may not address every Takaful-specific issue.

22. Role of the IFSB

The Islamic Financial Services Board (IFSB) provides standards and guidance relevant to Islamic financial services, including Takaful.

For Takaful, its guidance covers areas such as:

solvency

and

risk management.

Therefore, regulators can consider:

IAIS

for the broader insurance regulatory and supervisory framework,

together with:

IFSB

for guidance addressing Islamic financial services and Takaful-specific considerations.

So:

IAIS + IFSB → Useful regulatory guidance for Takaful supervision

23. Why Can’t One Country Simply Copy Another Country’s Takaful Regulations?

A regulatory framework that works successfully in one jurisdiction may not automatically work in another.

Countries can differ in:

legal systems

market size

financial development

Takaful industry maturity

available Islamic investment instruments

consumer behaviour

business structures

and

Shari’ah governance frameworks.

Therefore:

Regulation should be adapted to the local business environment rather than copied mechanically from another jurisdiction.

24. Example - Same Regulation, Different Business Environment

Suppose Country A has a highly developed Islamic capital market containing:

many Sukuk

Islamic money-market instruments

and

Shari’ah-compliant equities.

Its Takaful operators therefore have many investment choices.

Now suppose Country B has a much smaller Islamic capital market with very few suitable Shari’ah-compliant investment instruments.

If Country B simply copies Country A’s investment rules, Takaful operators in Country B may face:

excessive concentration

liquidity problems

or

difficulty complying with the requirements.

Therefore:

Same Regulation + Different Environment = Potentially Different Outcome

Regulations need to reflect local circumstances.

25. Local Shari’ah Interpretation Must Also Be Considered

Takaful regulation has an additional dimension:

Shari’ah interpretation

Different jurisdictions may adopt different Shari’ah governance approaches or interpretations regarding certain fiqh al-muʿāmalāt issues.

Fiqh al-muʿāmalāt broadly refers to Islamic jurisprudence concerning transactions and commercial dealings.

These issues can affect matters such as:

Wakalah

Mudarabah

tabarru’

qard

investment structures

surplus arrangements

and other financial transactions.

Therefore, when a regulatory approach is transferred from one jurisdiction to another, regulators need to consider whether it is compatible with the applicable local Shari’ah framework.

26. Does Shari’ah Compliance Mean Regulation Can Be Less Prudent?

No.

This is an extremely important point.

Shari’ah constraints should not be used as an excuse to reduce:

solvency standards

risk-management standards

participant protection

or

financial discipline.

Instead, Takaful regulation must achieve both objectives simultaneously:

Prudential Soundness

and

Shari’ah Compliance

Therefore:

Shari’ah Compliance ≠ Weaker Financial Regulation

Instead:

Prudent Regulation + Shari’ah Compliance = Sound Takaful Regulation

The Whole Regulatory Process

You can understand the entire topic as one chain:

Identify Risks

↓

Determine Who Bears Each Risk

↓

Require Appropriate Resources

↓

Capital + Skilled People + IT Systems + Governance

↓

Monitor Risk-Based Capital

↓

Early Intervention When Financial Position Weakens

↓

Protect Participants

↓

Require Fair Treatment

↓

Maintain Sustainable Operator Incentives

↓

Avoid Excessively Restrictive Regulation

↓

Use IAIS + IFSB Guidance

↓

Adapt Regulation to Local Business and Shari’ah Environment

↓

Sound and Sustainable Takaful Industry

Easy Way to Remember

RISK – RESOURCES – PROTECT – BALANCE – ADAPT

RISK

Identify the risks and determine who bears them.

RESOURCES

Ensure sufficient capital, skilled people, technology and systems.

PROTECT

Protect participants through fair-treatment and prudential requirements.

BALANCE

Protect participants while allowing the operator to remain sustainable and encouraging appropriate innovation.

ADAPT

Use international guidance but adapt regulation to the local business environment and applicable Shari’ah framework.

Simple Formula

The basic regulatory principle is:

Risk Exposure → Required Resources

For capital:

Greater Risk → Generally Greater Required Capital

A simplified capital monitoring ratio is:

Available Capital ÷ Required Capital × 100% = Capital Adequacy Ratio

If the ratio falls toward a predetermined regulatory intervention level:

Early Warning

↓

Regulatory Intervention

↓

Corrective Action

↓

Reduced Risk of Financial Failure

Most Important Concept

Takaful regulation should not focus only on:

“How much capital does the operator have?”

A sound Takaful operation requires:

Capital

• ●

Competent Human Resources

• ●

Strong IT Systems

• ●

Risk Management

• ●

Fair Participant Treatment

• ●

Appropriate Pricing

• ●

Good Governance

• ●

Shari’ah Compliance

Therefore:

Capital is only one part of the resources required for a safe and sustainable Takaful operation.

One-Sentence Summary

Regulation and supervision of Takaful begin by identifying and allocating risks and then ensuring sufficient financial, human and technological resources are available to manage those risks; regulators must also protect participants, monitor solvency, maintain appropriate incentives for operators, avoid unnecessarily restricting innovation, and use international guidance such as IAIS and IFSB in a way that is appropriate to the local business environment and applicable Shari’ah framework.