Takaful - Understanding Underpricing, Underwriting Loss and Shareholders’ Capital

The sentence means:

If a conventional insurer deliberately charges premiums that are too low in order to attract more customers and increase sales, it may initially appear successful. However, when claims eventually arise, the inadequate premiums may cause underwriting losses, which ultimately reduce the shareholders’ capital.

1. What Does “Deliberately Underpricing” Mean?

Underpricing means charging a premium that is lower than the amount actuarially required to support the risk and associated costs.

For example, suppose actuarial calculations indicate that the appropriate premium should be:

RM1,000 per policy

This RM1,000 is needed to support expected claims, expenses and an appropriate allowance for uncertainty.

However, the insurer deliberately charges only:

RM700

Why?

Because cheaper insurance may attract more customers.

So:

Proper price = RM1,000

Actual price charged = RM700

Underpricing = RM300

2. Why Would an Insurer Deliberately Underprice?

The insurer might want to increase its turnover, meaning its volume of business or premium income.

Suppose:

Before reducing the price

Premium = RM1,000

Customers = 10,000

Premium turnover:

RM1,000 × 10,000 = RM10 million

Now the insurer reduces the price to:

RM700

Because it is much cheaper, it attracts:

20,000 customers

Premium turnover becomes:

RM700 × 20,000 = RM14 million

So premium turnover has increased:

RM10m → RM14m

At first, this looks impressive.

Customers ↑

Policies sold ↑

Premium turnover ↑

Management might say:

“Our business is growing rapidly.”

But there is a hidden problem.

3. The Risks Have Not Become Cheaper Just Because the Premium Was Reduced

Suppose the expected claims cost is:

RM800 per policy

With 20,000 customers:

Expected claims = RM800 × 20,000

= RM16 million

But the insurer collected only:

RM14 million premiums

Even before considering other relevant expenses:

Premium income = RM14m

Expected claims = RM16m

Therefore:

RM14m − RM16m = −RM2m

The insurer has an expected RM2 million underwriting shortfall in this simplified example.

So increasing sales does not help if every new policy is inadequately priced.

4. More Sales Can Actually Make the Problem Bigger

This is a very important concept.

Imagine the insurer loses approximately:

RM100 on every policy

If it sells:

1,000 policies

Potential loss:

RM100,000

If it sells:

100,000 policies

Potential loss:

RM10 million

Therefore:

Selling more underpriced policies can increase losses rather than solve them.

This is why:

Higher turnover ≠ Higher profitability

if the underlying business is badly priced.

5. What Is an Underwriting Loss?

An underwriting loss occurs when the relevant premiums are insufficient to cover claims and underwriting-related expenses for the period.

A simplified formula is:

Underwriting Result = Premium Income − Claims − Underwriting Expenses

Suppose:

Premium income = RM100 million

Claims = RM90 million

Underwriting expenses = RM20 million

Then:

RM100m − RM90m − RM20m = −RM10m

The insurer has:

RM10 million underwriting loss

6. Why Does This Eventually Affect Shareholders’ Capital?

In conventional insurance, the insurer itself bears the underwriting risk.

The premiums belong to the insurance business, and the insurer is contractually responsible for paying covered claims.

Suppose:

Insurer’s assets/resources from operations are insufficient by:

RM20 million

The insurer cannot simply tell policyholders:

“Our premiums were too low, so we will not pay your valid claims.”

The insurer remains responsible for its contractual obligations.

Therefore, persistent underwriting losses ultimately reduce the insurer’s financial resources and can erode the capital attributable to shareholders.

7. Simple Example of Capital Being Depleted

Suppose a conventional insurer starts with:

Shareholders’ capital = RM100 million

Year 1

Underwriting loss = RM10m

Simplified remaining capital:

RM90m

Year 2

Underwriting loss = RM20m

Remaining:

RM70m

Year 3

Underwriting loss = RM30m

Remaining:

RM40m

If losses continue, the financial buffer becomes progressively weaker.

This is what is meant by:

“Underwriting losses deplete shareholders’ capital.”

The actual accounting and solvency calculation is more complex, but this illustrates the economic idea.

8. Why Is the Word “Eventually” Important?

Underpricing may not look dangerous immediately.

Imagine the insurer launches a very cheap product in January.

Thousands of customers purchase it.

Immediately, the insurer receives:

large amounts of premium cash

Management sees:

Sales ↑

Customer numbers ↑

Premium turnover ↑

But many claims may occur only later.

Therefore, initially:

Money comes in first

while:

many claims come later

This can create the appearance of success.

Eventually, when the claims develop, the insurer discovers that the premiums were insufficient.

So:

Today → High sales look successful

Later → Claims emerge

Later still → Underwriting losses become clear

That is why deliberately underpricing can create temporary growth but long-term financial weakness.

9. This Is Very Important for Your Takaful Topic

Now compare this with Takaful.

Conventional Insurance

Insurer deliberately underprices.

↓

More customers buy insurance.

↓

Turnover temporarily increases.

↓

Premiums are insufficient for the risks accepted.

↓

Claims emerge.

↓

Underwriting losses occur.

↓

Insurer/shareholders ultimately suffer financially and capital can be depleted.

Takaful

Suppose the Takaful operator underprices to attract more participants.

↓

More participants join.

↓

Contribution turnover increases.

↓

Wakalah fee income may increase.

↓

But after deducting the Wakalah fee, insufficient tabarru’ may enter the PRF.

↓

Claims emerge.

↓

PRF experiences deficit.

This is the conflict you were studying earlier.

10. Why This Creates a Special Agency Concern in Takaful

In conventional insurance, shareholders have a direct financial reason to stop persistent underpricing because:

Poor pricing → Underwriting loss → Shareholder capital affected

But under a Wakalah Takaful structure:

Operator receives Wakalah fee

while:

PRF bears underwriting risk

Therefore, if the incentive structure is poorly designed:

Operator may benefit from higher turnover

while:

Participants’ Risk Fund suffers the consequences of inadequate pricing.

That is why Takaful governance needs to align:

Operator interests

with

Participant/PRF interests.

Very Simple Example

Imagine two businesses selling something that costs them:

RM100

Business A

Selling price:

RM120

Profit per item:

RM20

It sells 1,000 items.

The business is sustainable.

Business B

Selling price:

RM80

Loss per item:

RM20

Because it is so cheap, it sells 10,000 items.

Management proudly says:

“We sold ten times more!”

But:

RM20 loss × 10,000 = RM200,000 loss

So the increase in turnover actually magnified the problem.

The same basic logic applies to insurance underpricing.

Easy Way to Remember

Think:

CHEAP → MORE SALES → MORE CLAIMS → LOSSES → CAPITAL ↓

More precisely:

Underpricing

↓

More customers

↓

Higher temporary turnover

↓

Premiums insufficient for risks

↓

Claims eventually emerge

↓

Underwriting losses

↓

Shareholders’ capital depleted

Simple Formula

Underwriting Result = Premium Income − Claims − Underwriting Expenses

If:

Premium Income < Claims + Underwriting Expenses

then:

Underwriting Loss

If significant underwriting losses continue:

Repeated Underwriting Losses → Reduced Financial Resources → Depletion of Shareholders’ Capital

One-Sentence Summary

In conventional insurance, deliberately charging premiums below an actuarially adequate level may temporarily attract more customers and increase turnover, but when claims eventually emerge, the inadequate premiums can produce underwriting losses that reduce the insurer’s financial resources and ultimately deplete shareholders’ capital.