Takaful - What Is Underwriting Risk?

Underwriting risk is the risk that the actual claims and costs of the Takaful business turn out to be higher than expected when the operator originally assessed and accepted the risks.

In simple terms:

Underwriting risk = the possibility that the Takaful risk pool has to pay more claims than it expected.

Suppose a Takaful operator expects:

Contributions collected = RM10 million

Expected claims = RM6 million

Expected expenses and reserves = RM3 million

That leaves:

RM1 million buffer/surplus

But during the year, actual claims become:

RM9 million

Now the Takaful risk pool faces much greater pressure than originally expected.

That difference between expected and actual claims is part of underwriting risk.

Why Does Underwriting Risk Arise?

It can arise because the operator may incorrectly estimate:

how often claims will happen

or

how large the claims will be

For example, the operator may expect 1,000 motor accidents but actually receive 1,500 claims.

Or it may expect the average claim to be RM5,000, but the actual average becomes RM8,000.

Example - Motor Takaful

Suppose 10,000 drivers participate in a Motor Takaful scheme.

The operator estimates that:

500 drivers will make claims

Average claim:

RM10,000

Expected total claims:

500 × RM10,000 = RM5 million

But during the year:

800 drivers make claims

and the average claim rises to:

RM12,000

Actual claims become:

800 × RM12,000 = RM9.6 million

The PRF expected RM5 million of claims but actually has to deal with RM9.6 million.

That is a clear example of underwriting risk.

Example - Large Factory

Suppose a Takaful operator accepts a factory risk and estimates that a major fire is very unlikely.

The operator retains a large portion of the risk.

Then a serious fire occurs and creates a claim of:

RM50 million

If the operator did not retain enough reserves or arrange sufficient Retakaful, the PRF could suffer a major deficit.

That is also underwriting risk.

Underwriting Risk Has Two Main Parts

Frequency Risk

This means:

More claims happen than expected.

Example:

Expected claims = 500

Actual claims = 900

Severity Risk

This means:

Claims are larger than expected.

Example:

Expected average claim = RM5,000

Actual average claim = RM15,000

So:

Underwriting Risk = Frequency Risk + Severity Risk

Who Bears the Underwriting Risk in Takaful?

This is very important.

In Takaful, the Participants’ Risk Fund (PRF) bears the underwriting risk.

The Takaful operator manages that fund as the wakil/manager under a Wakalah model.

So:

Takaful Operator = manages the risk

Takaful Risk Pool = bears the underwriting risk

That is why Retakaful is arranged for the Takaful risk pool, because that is the fund exposed to excessive claims.

How Can Underwriting Risk Be Reduced?

The operator can reduce it through:

careful underwriting

appropriate pricing/contribution rates

diversification

adequate reserves

claims management

and

Retakaful

For example, if a single factory risk is too large, the operator can retain only part of it and cede the rest to Retakaful.

Easy Way to Remember

Underwriting asks:

“Should we accept this risk, and on what terms?”

Underwriting risk asks:

“What if the risk turns out worse than we expected?”

Simple Formula

Expected Claims < Actual Claims

or

Expected Severity < Actual Severity

= Underwriting Risk

One-Sentence Summary

Underwriting risk is the possibility that the claims experience of the Takaful risk pool is worse than expected, causing the fund to pay more than was originally anticipated.