Saudi Arabia's cooperative sukuk model offers distinct advantages

While the rapid development of the global Islamic banking sector has generated plenty of media headlines in recent years, the growth of the takaful industry has attracted comparatively less attention. There are several reasons that can go some way to explain the relatively unheralded expansion of the world’s sharia-compliant insurers. For example, their aggregate asset base is considerably smaller than that of their banking peers, and the adoption of takaful in areas where Islamic banking is well established has been inconsistent, marked by a more varied performance than Islamic banking operations.

Nevertheless, the growth trajectory of global takaful has been impressive, and the prospects of a continuation of this trend are also good: in its 2014 survey of global takaful, EY announced the continued double-digit growth of takaful. Growing at an estimated 14% in 2014, it predicted that by 2017 the global industry could pass the $20bn milestone.

Starring Role

Saudi Arabia has played the starring role in the gradual emergence of takaful. Indeed, for years the country has been the single-largest contributor to global gross takaful contributions, and in 2014 it accounted for an estimated 48% of the total – far in advance of the 30% which the combined takaful industries of Malaysia and Indonesia added to the market, and the 15% contribution of the rest of the GCC. At the same time, not all industry reports have established the Kingdom as the primary mover in the global takaful market, as some analysts choose to place the insurance model followed by Saudi-licensed companies in a separate classification to the generally accepted definition of takaful.

These discrepancies in classification are the result of the nation’s adoption of a cooperative model of insurance that, although sharia-compliant in the view of the majority of Islamic scholars, still differs from takaful as practised elsewhere in some important aspects. Saudi Arabia’s cooperative insurance model brings both advantages and challenges to the participants in the nation’s young but rapidly expanding insurance industry.

Cooperative vs Takaful

Any discussion regarding the merits of the Saudi cooperative model as opposed to takaful is complicated by the fact that takaful means something very close to cooperation in Arabic (literally, mutual obligation). There are, however, important differences in how the two concepts are applied in the Kingdom. Takaful in the broad sense is not a new phenomenon, coming into being as early as the second century as a form of mutual marine protection to cover robberies and mishaps.

The modern era of sharia-compliant insurance emerged in 1979, after the sharia committee of a Sudanese Islamic bank ruled against insuring the firm’s assets with a commercial insurance company – a decision which provided the impetus for the creation of the first takaful company in the world: the Islamic Insurance Company of Sudan. In 1985 Saudi Arabia provided the stage for another important act in the development of takaful when the Islamic Fiqh Academy announced at the second session of the Organisation of the Islamic Conference in Jeddah that commercial insurance contracts are prohibited under sharia law. Takaful, as a form of cooperative insurance, was therefore established as the only acceptable alternative.

Although there are some subtle differences in the manner of its implementation across various jurisdictions, it differs from conventional insurance in its prohibition of maisir (or gambling, so that the underwriting of risks in anticipation of a profit is outlawed), gharar (uncertainty, such as the acceptance of premiums in exchange for indemnity against risks which may not occur) and riba (usury, so that takaful operators cannot hold securities from companies which derive their income from interest or prohibited industries). Another feature is the requirement that each company must keep the contribution of its participants, or customers, separate from those of its shareholders, meaning that should the policyholders’ fund be depleted it cannot be supported by the shareholders’ fund.

During the 1980s most takaful operations were carried out under the mudarabah (profit sharing) model, by which the providing company and its clients agreed on a ratio for the division of any surplus. In the 1990s the wakala (agency) model was established, and has since become the most popular form of takaful in the Gulf region. Rather than sharing profit, according to wakala principles the takaful operator acts as an agent on behalf of the participants and earns a fee for services rendered. Until recently, many sharia-compliant insurance operators in Saudi Arabia conducted their operations according to the wakala model, with companies such as Al Ahli Takaful and Al Rahji Takaful establishing themselves as regional players in this segment.

All this changed in 2004 with the implementation by the Saudi Arabian Monetary Agency (SAMA) of the Cooperative Insurance Companies Control Law. The legislation introduced a new model for insurance operations which all market participants were compelled to adopt. Although Islamic in nature, which explains why the Saudi market is categorised as takaful by many global industry reports, the Saudi Arabian cooperative model differs from the standard takaful model in a number of important ways. For example, under the Kingdom’s regime there is no requirement to segregate the policyholder funds from the funds of the shareholders, and cooperative insurance companies are not compelled to invest in accordance with the principles of sharia. Neither are Saudi insurance companies asked to appoint a sharia supervisory board, which the takaful model as applied in most jurisdictions requires.

Several Advantages

The Saudi cooperative model offers several advantages to industry participants. Insurers are better able to formulate more sophisticated investment strategies than many of their regional peers, thanks to their freedom to direct capital to a wider range of industries and instruments. Moreover, the fact that the policyholders’ fund has full access to the shareholders’ fund makes the cooperative model a more sustainable one than the traditional takaful model, establishing it as a much safer way of doing business in the eyes of many industry observers. Further to this, there is the significant issue of regulatory clarity: while the Saudi Cooperative Insurance Companies Control Law has put in place a straightforward framework that has allowed the domestic industry to thrive, other jurisdictions face the challenge of a rapidly evolving and relatively ungoverned industry where new hybrids of mudarabah and wakala are emerging.

These advantages have helped Saudi insurers to operate more efficiently than regional competitors. The cooperative model utilises the mudarabah contract, by which policyholders and insurers share the risks associated with a policy as well as the profits from invested premiums, providing a strong incentive for Saudi companies to cut costs. Markets where wakala or wakala hybrids remain the norm do not have this incentive and tend to have higher prices and costs, which eat into margins and revenues. This key difference largely explains why the return on equity ratio for the Saudi insurance industry normally reaches double digits and stood at 10% in 2014 according to research carried out by Mohammed Atef, CFO of Arabian Shield. By contrast, the return on equity of the UAE takaful sector is around 0.5%.

Scholarly Consensus

Saudi Arabia’s system does, of course, come with its own challenges. The question of the sharia compliance of insurance activity is one with a storied past, and although most sharia scholars in the country are satisfied that the cooperative model is in keeping with the precepts of sharia law, this has not stopped some companies from attempting to differentiate themselves from the rest of the market by claiming that they are closer to “pure” takaful than their competitors. Within the framework of the cooperative model, there are a number of ways in which this can be attempted, principally in the area of investment activities. For example, some companies direct funds to term deposits, while others declare term deposits haram (forbidden) as they bear interest.

Similarly, some companies have highlighted that they do not invest in bonds and have accordingly restricted themselves solely to sukuk (Islamic bonds). Further scope for differentiation comes with a company’s investment position with regard to stocks, with some companies only investing in equities that have been declared as sharia compliant by a sharia committee. All of these strategic variations, however, are able to take place within the bounds of the cooperative model, which can remain in place as the sole standard that industry participants must meet. The flexibility that is allowed by the Saudi regulatory framework, circumscribed by well regulated and unambiguous parameters, is one of its key strengths.