Takaful - Role of an Actuary in Determining Surplus

An important responsibility of the actuary in Takaful is not only to calculate whether the Participants’ Risk Fund (PRF) has generated an underwriting surplus, but also to determine:

whether that surplus is safe to distribute, how much can be distributed, and who is eligible to receive it.

The most important principle is:

The existence of a surplus does not automatically mean that the entire surplus should be distributed.

Some or all of the surplus may need to remain in the PRF as a financial buffer against future claims volatility.

1. First, What Is a Surplus?

Recall the basic concept.

Suppose the PRF receives:

Relevant PRF income = RM20 million

During the year:

Claims = RM12 million

Retakaful costs = RM2 million

Other relevant expenses/provisions = RM3 million

Simplified result:

RM20m − RM12m − RM2m − RM3m = RM3m

Therefore:

Underwriting surplus = RM3 million

There is a positive balance after the relevant obligations and provisions have been taken into account.

But the next question is:

Should the entire RM3 million now be distributed?

Not necessarily.

2. The Actuary Has to Assess the Surplus

The actuary considers whether distributing the surplus would leave the PRF financially strong enough to meet future obligations.

Therefore, the actuary is not simply asking:

“Is there a surplus?”

The more important question is:

“How much of this surplus, if any, can safely be distributed without jeopardising the PRF’s ability to pay future claims?”

This distinction is extremely important.

3. Surplus Does Not Automatically Mean Distribution

Suppose:

PRF surplus = RM10 million

It might seem attractive to distribute:

RM10 million

to eligible participants.

But suppose the actuary knows that claims are highly volatile.

Historical claims might have been:

Year 1 = RM10m

Year 2 = RM12m

Year 3 = RM25m

Year 4 = RM11m

Year 5 = RM30m

The PRF may have a surplus today, but another very large claims year could occur in the future.

Therefore, the actuary may recommend:

Retain part or all of the surplus in the PRF.

4. Why Retain Surplus?

One major reason is to create a margin or buffer against fluctuations in claims experience.

Remember:

Expected claims ≠ Actual claims

Suppose expected claims next year are:

RM15 million

But actual claims could become:

RM20 million

or:

RM25 million

because of unexpected adverse events.

If previous surpluses were retained, the PRF has additional resources to absorb the higher claims.

Therefore:

Retained Surplus → Stronger PRF → Greater Ability to Absorb Claims Volatility

5. Example - Distribute Everything vs Retain Surplus

Suppose the PRF has:

RM5 million surplus

Situation A - Distribute Everything

The entire:

RM5m

is distributed.

PRF retained surplus:

RM0

Next year an unexpectedly large claim produces an additional:

RM4m requirement

The PRF has no accumulated surplus available to absorb it.

This increases the possibility of:

PRF deficit → Qard requirement

Situation B - Retain RM4 Million

Suppose the actuary recommends:

Distribute RM1m

and

Retain RM4m

Next year there is an unexpected:

RM4m adverse claims experience

The accumulated RM4m can help absorb that adverse experience.

Therefore:

Retaining surplus today can protect participants against claims tomorrow.

6. What Does “Margin Against Fluctuation in Claims Experience” Mean?

This is closely related to your earlier question about margin.

Claims do not remain exactly the same every year.

For example:

Year 1 claims = RM5m

Year 2 = RM7m

Year 3 = RM6m

Year 4 = RM15m

Year 5 = RM8m

The sudden RM15m year illustrates claims volatility.

Therefore, the PRF needs some financial cushion.

Accumulated surplus can provide part of this cushion.

So:

Claims Volatility → Need for Financial Buffer → Retain Appropriate Surplus

7. Important - This Is Related to, but Different From, a Pricing Margin

You previously studied margin in pricing.

We should distinguish the two ideas.

Pricing Margin

Included when determining an appropriate contribution or risk price.

It is forward-looking.

For example:

Expected claims = RM700

Pricing margin = RM100

Required claims-related pricing allowance = RM800

Retained Surplus as a Buffer

This arises after actual experience has produced a surplus.

Instead of distributing the entire surplus, some is retained in the PRF to strengthen the fund against future adverse claims.

For example:

Actual underwriting surplus = RM5m

Actuary recommends retaining = RM4m

Distributable amount = RM1m

So both provide protection against uncertainty, but they arise at different stages.

8. The Actuary Must Protect Future Claim-Paying Ability

The most important consideration is:

Will the PRF still be capable of paying future claims after the surplus distribution?

Suppose:

PRF assets/resources = RM100m

Potential surplus = RM10m

The operator wants to distribute the entire RM10m.

But actuarial analysis indicates that the PRF needs approximately:

RM96m

to maintain an appropriate financial position for its future obligations and risks.

If RM10m were distributed:

RM100m − RM10m = RM90m

But the PRF needs:

RM96m

Therefore, distributing RM10m could weaken the PRF excessively.

The actuary may therefore conclude that the full RM10m should not be distributed.

9. The Actuary May Recommend Only Part of the Surplus

Suppose:

Total surplus = RM10m

Based on claims volatility and future obligations, the actuary determines that:

RM7m should remain in PRF

Therefore:

Potential distributable surplus:

RM10m − RM7m = RM3m

So:

Total Surplus ≠ Distributable Surplus

This is a very important distinction.

10. What Is “Distributable Surplus”?

Distributable surplus means the portion of the available surplus that can appropriately be distributed under the applicable rules without weakening the PRF’s ability to meet its obligations.

For example:

Total underwriting surplus = RM8m

Required amount to be retained = RM5m

Potential distributable amount = RM3m

Therefore:

RM8m surplus does not necessarily mean RM8m distribution.

The actuary’s assessment is crucial.

11. Malaysia - Actuarial Assessment Before Distribution

Under the Malaysian regulatory approach described here, surplus distribution is subject to an actuarial assessment.

The actuary needs to be satisfied that the proposed distribution will not jeopardise future claim payments from the risk fund.

In simple terms:

Participants should not receive a large surplus distribution today if doing so could leave insufficient resources to pay participants’ claims tomorrow.

This reflects the principle of financial prudence.

12. Why Must the Accounts Be Audited?

The accounts should also be audited before surplus is distributed.

Why?

Because before distributing money, there should be sufficient confidence that the reported financial position is reliable.

Suppose management calculates:

Surplus = RM10m

But after proper review, it is discovered that:

RM3m of claims had not been properly recognised.

The true position may be substantially different.

Therefore, auditing provides additional assurance over the financial information used in determining the surplus.

13. Actuary and Auditor Have Different Roles

Do not confuse the two.

Actuary

Focuses heavily on matters such as:

claims liabilities

future uncertainty

claims volatility

financial adequacy

and

whether surplus distribution is prudent.

Auditor

Examines whether the financial statements are appropriately prepared and presented according to the relevant financial reporting framework.

Therefore:

Actuarial Assessment + Audited Accounts → Stronger Basis for Surplus Distribution

14. Claims Volatility Is Extremely Important

The more volatile the claims experience, the more cautious the actuary is likely to be about surplus distribution.

Why?

Because:

High volatility = Greater uncertainty about future claims

Suppose two PRFs each have:

RM5m surplus

But their claims histories are very different.

PRF A

Claims:

RM10m → RM10.5m → RM9.8m → RM10.2m → RM10.4m

Claims are relatively stable.

PRF B

Claims:

RM5m → RM18m → RM7m → RM25m → RM6m

Claims are highly volatile.

Although both currently have RM5m surplus, the actuary may be much more cautious about distributing PRF B’s surplus.

15. Why?

Because PRF B has demonstrated that a:

“Big claim”

or bad claims year can arise unexpectedly.

If the entire RM5m is distributed today and a major claim occurs next year, the PRF could fall into deficit.

Therefore:

Greater Claims Volatility

↓

Greater Need for Buffer

↓

Greater Surplus Retention

↓

Less Likely/Less Amount to Be Distributed

16. What Does “Save It for the Next Big Claim” Mean?

Suppose:

Year 1 surplus retained = RM2m

Year 2 surplus retained = RM3m

Year 3 surplus retained = RM2m

Accumulated surplus:

RM2m + RM3m + RM2m = RM7m

Now in Year 4, an unexpectedly bad claims year creates an additional:

RM6m adverse claims experience

The PRF has:

RM7m accumulated surplus

available as a financial buffer.

Therefore, the fund is much better positioned to absorb the bad year.

This is the benefit of surplus accumulation.

17. Retaining Surplus Can Reduce Dependence on Qard

This connects directly with what you studied earlier.

Suppose the PRF has no accumulated surplus.

Unexpected adverse claims create:

RM5m deficit

The shareholder/operator fund may have to provide:

RM5m qard, depending on the applicable arrangement.

But suppose the PRF had previously accumulated:

RM6m retained surplus

The RM5m adverse experience may be absorbed by the PRF’s own accumulated resources.

Therefore:

Retained Surplus → Stronger PRF → Lower Reliance on Qard

This supports the mutual nature of Takaful.

18. Risk Sharing Is Not Only Between Participants in the Same Year

This is one of the most important ideas here.

Normally, when we think about Takaful risk sharing, we imagine:

Ahmad + Ali + Sarah + Fatimah

all contributing to the PRF in the same year.

If Ahmad suffers a covered loss, the common fund pays Ahmad’s claim.

That is:

Risk sharing among current participants.

But Takaful risk sharing can also extend across time through the accumulation of the PRF.

19. Risk Sharing Between Different Years

Imagine:

Year 1

10,000 participants contribute.

Claims are low.

Surplus retained:

RM3m

Year 2

Another group of participants contributes.

Claims are also relatively low.

Additional surplus retained:

RM2m

Accumulated surplus:

RM5m

Year 3

Participants experience unusually high claims.

The PRF needs an additional:

RM4m

The accumulated RM5m from earlier years can help absorb the Year 3 claims.

Therefore, resources built up when earlier participants experienced favourable claims can support the risk pool when later participants experience unfavourable claims.

This creates an intertemporal dimension of risk sharing.

20. What Is Intertemporal Risk Sharing?

Intertemporal simply means:

Across different periods of time.

So Takaful risk sharing can occur:

Horizontally

Among many participants within the same period.

and

Intertemporally

Through the PRF’s accumulated resources across different years.

For example:

Current Participants → Build PRF Surplus → Retain Surplus → Future Participants/Claims Benefit

This is why distributing every surplus immediately may weaken the long-term mutual risk-sharing function.

21. Important Clarification

This does not mean that every future participant personally owns the surplus generated by previous participants.

The exact ownership, eligibility for distribution and treatment of surplus depend on the applicable Takaful model, certificate terms and regulatory/Shari’ah framework.

The important economic concept is:

Retaining appropriate surplus allows the PRF to absorb fluctuations across different periods rather than treating each year as completely isolated.

22. Why This Makes the PRF Stronger

Suppose the PRF distributes every surplus immediately.

The pattern becomes:

Good year → Distribute everything

Bad year → Deficit

Good year → Distribute everything

Bad year → Deficit

This creates instability.

A more prudent approach may be:

Good year → Retain appropriate surplus

↓

Another good year → Build additional buffer

↓

Bad year → Use accumulated buffer

↓

PRF remains stronger.

Therefore:

Surplus Accumulation Smooths Claims Volatility Across Time

23. The Actuary’s Decision Process

The actuary essentially considers:

Is there an actual surplus?

↓

What future claims and liabilities exist?

↓

How volatile are claims?

↓

How strong is the PRF?

↓

How much financial buffer should remain?

↓

Would distribution jeopardise future claims?

↓

If safe:

Recommend an appropriate distributable amount

If not safe:

Retain surplus in PRF

24. Three Possible Outcomes

Suppose total surplus is:

RM10 million

The actuary might conclude:

Outcome 1 - Full Distribution

If financial conditions are sufficiently strong under the applicable rules:

Distribute RM10m

Outcome 2 - Partial Distribution

For example:

Distribute RM3m

Retain RM7m

Outcome 3 - No Distribution

If claims volatility and future obligations are too uncertain:

Distribute RM0

Retain RM10m

Therefore:

Having a surplus does not create an automatic right to immediate full distribution.

25. Connection With Solvency

Surplus distribution and solvency are directly connected.

If too much surplus is distributed:

PRF resources ↓

↓

Financial buffer ↓

↓

Ability to absorb unexpected claims ↓

↓

Probability of deficit ↑

↓

Potential qard dependence ↑

Therefore, actuarial oversight helps ensure that surplus distribution does not undermine the financial sustainability of the PRF.

Easy Way to Remember

Use:

SURPLUS → CHECK → RETAIN → DISTRIBUTE

SURPLUS

Determine whether a genuine surplus exists.

CHECK

Actuary assesses future claims, volatility and financial strength.

RETAIN

Keep enough surplus in the PRF as a buffer.

DISTRIBUTE

Only the amount that can prudently be distributed should be considered for distribution according to the applicable rules.

Simple Formula

A useful conceptual formula is:

Total Surplus − Required Retained Buffer = Potential Distributable Surplus

For example:

RM10m − RM7m = RM3m

Therefore:

Total surplus = RM10m

does not necessarily mean:

Distribution = RM10m

It could mean:

RM7m retained + RM3m distributed

depending on actuarial assessment and applicable requirements.

Relationship With Claims Volatility

The principle can be remembered as:

Higher Claims Volatility → Greater Need for Retained Surplus → Lower Likelihood/Amount of Distribution

Conversely, relatively stable claims may give the actuary greater confidence, although other financial factors still need to be considered.

Relationship With Risk Sharing

Within the Current Year

Many Current Participants → Common PRF → Claims of the Few

Across Different Years

Current Surpluses → Retained in PRF → Future Claims

Therefore:

Takaful risk sharing can operate both among participants in the same period and across different periods through the accumulation of the risk fund.

One-Sentence Summary

The actuary determines not only whether the Participants’ Risk Fund has a surplus but also whether any of that surplus can safely be distributed, how much should be retained as a buffer against future claims volatility, and the appropriate distribution under the applicable rules; greater claims volatility generally supports greater surplus retention because accumulated surplus strengthens the PRF, protects future claim-paying ability and enables risk sharing across different periods.