Evolution and growth: From banking to insurance, the sector has considerable potential for expansion

Long a key participant in the global Islamic finance arena, Saudi Arabia secured its position in 2013 by becoming the largest issuer of sukuks (Islamic bonds) in the region for the second year in a row. With a banking industry in which sharia-compliant assets account for a growing share each year, and an insurance sector that has operated on an Islamic basis since its inception, the Kingdom’s status as a leading centre for Islamic financial services (IFS) is likely to continue well into the future.

REGIONAL LEADER: Given the status of sharia principles in Saudi Arabia’s legal system, it is hardly surprising that the country has played such a central role in the development of the modern IFS industry. The Kingdom is home to Islam’s two most holy sites, and its legal system is infused with the precepts of Islamic law derived from the Quran and the Sunnah (the practices and sayings of the Prophet Muhammad during his lifetime), which serve as the reference point for civil and criminal legal proceedings.

In this context, Saudi Arabia was in the vanguard of efforts in the 1970s to liberalise the GCC’s financial sector and develop a sharia-compliant model of finance. The nation assumed a leading role in a series of regional conferences that were convened to this end, and in 1975 it became home to the Jeddah-based Islamic Development Bank (IDB), founded by a group of finance ministers at the first Organisation of the Islamic Conference (now known as the Organisation of Islamic Cooperation, or OIC). One of the largest sharia-compliant entities in the world, the IDB’s 56 member countries (as of 2014) work together to bring about the organisation’s primary goals of fostering the social and economic development of member countries and individual Muslim communities in accordance with the principles of sharia. Saudi Arabia is the largest contributing member of the bank in terms of paid-up capital, holding around 26.5% of the total. In the period between its foundation and 2012 the IDB approved $87.2bn worth of financing in the region, more than 50% of which was directed to trade finance, with the bulk of the remainder earmarked for project financing. In this way, the IDB has encouraged the development of electricity generation and transmission, communications infrastructure, water and sanitation, and housing, transport and infrastructure projects primarily throughout the regions of MENA and Asia. As the bank’s largest stakeholder, Saudi Arabia has therefore played an important role in the furtherance of sharia-compliant financing both within the GCC and beyond.

OVERSIGHT & REGULATION: Despite the Kingdom’s prominence within the global IFS sector, its domestic sharia-compliant industry is governed in a manner which differs from many other jurisdictions. The Saudi Arabian Monetary Agency (SAMA), the nation’s central bank, supervises all aspects of the financial system, including the setting of monetary policy, management of foreign exchange reserves, and the licensing and regulation of commercial banks.

SAMA has chosen to operate a relatively more relaxed regulatory framework with respect to sharia compliance than many of its neighbours, a decision which has resulted in a diverse market in terms of products and services. For example, in the comparably large Malaysian IFS sector all new products and services must be approved by Bank Negara Malaysia, the nation’s central bank. Saudi Arabia’s lighter regulatory touch, in contrast, allows Islamic financial institutions to assess the compatibility of their offerings with the precepts of sharia themselves – a process which is normally undertaken by an internal sharia board. The degree to which institutions adhere to sharia therefore varies considerably across the sector, with some banks marketing themselves as strictly Islamic and others taking a more conventional tack.

In general terms, the retail banking segment is almost entirely run on sharia lines, whereas the corporate segment is largely conventional – albeit with a marked shift towards increased sharia compliance over recent years as Islamic offerings have grown in complexity and become less costly. However, despite the high degree of discretion enjoyed by the Kingdom’s Islamic institutions in conducting their business, they are not left without direction when it comes to formulating their products and services. As well as their internal sharia boards, sharia-compliant operations have recourse to a number of IFS authorities for guidance, the most prominent of which are Malaysia’s Financial Services Board and the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions.

BANKING: The Kingdom’s Islamic banking sector is comprised of a number of purely Islamic institutions, as well as conventional lenders with sharia-compliant assets. Taking both into account, some 53% of banking sector assets could be said to be sharia-compliant, according to the Ernst & Young “World Islamic Banking Competitiveness Report 2013-14”. Of the 11 locally licensed commercial banks, four are run on wholly Islamic lines. The largest of them in terms of assets is Al Rajhi, which posted a total of $75.62bn at end-2013. The bank, which was launched in 1957, is a subsidiary of the family-owned Al Rajhi Trading and Exchange Corporation. With more than 500 branches and 3100 ATMs in the Kingdom, it dominates the domestic retail market and has expanded its footprint to include Malaysia, Kuwait and Jordan.

Bank AlJazira, with total assets of $16bn at the close of 2013, is the second-largest Islamic bank in the Kingdom. Founded in 1975, it became fully sharia-compliant in 2007 and since 2011 has been implementing an expansion strategy financed by a $267m sukuk offered that year – one of the largest Islamic bond offerings of the past five years. The third-and fourth-largest Islamic banks as of the end of 2013 were Alinma Bank, with $16.8bn in total assets, and Bank Albilad, with $9.6bn. Other prominent Saudi banks with substantial sharia-compliant assets include National Commercial Bank (also known as Al Ahli Bank); SABB (formerly Saudi British Bank), which is affiliated with HSBC; Riyad Bank; Arab National Bank; and Banque Saudi Fransi, which is affiliated with Crédit Agricole Group (see Banking chapter).

POPULAR MODELS: The field of sharia-compliant financing is evolving rapidly, with sharia boards and Islamic financing associations across the world constantly interacting as new services and products are assessed and developed. Saudi Arabia’s banks, however, have passed most of their significant financing milestones on the back of one of two models.

Murabaha, whereby a bank purchases an asset on behalf of a client and then sells it on to the same client at a prearranged price, is one of the most popular Islamic finance products. The local sharia-compliant consumer financing market relies heavily on the instrument, which is suited to asset acquisition, and many local retail banks extend murabaha financing to clients interested in buying a car or, in some cases, a house. The structure has also been used to finance larger corporate deals, such as the 2012 arrangement by which Kuwaiti telecoms firm Zain funded its regional expansion with a $2.5bn murabaha structured by a number of Saudi banks. Another much-utilised form of Islamic financing locally is musharaka (partnership), by which a bank provides funding for a client to purchase an asset, with the two parties agreeing to share profits and losses for the asset. In general a musharaka deal entails less risk for lenders than a murabaha one.

PERFORMANCE: The Islamic banking segment has been outperforming its conventional equivalent over recent years. Lending by sharia-compliant institutions grew by a compound annual growth rate (CAGR) of 16.3% between 2007 and 2012, according to research from AlJazira Capital, compared to the 9.8% expansion of their conventional peers. In 2013 all four of the sector’s wholly Islamic financiers succeeded in growing their loan books, with the largest year-on-year increase being posted by Bank AlJazira (29.6%), followed by Bank Albilad (28.6%), Alinma Bank (20.81%) and Al Rahji Bank (8.65%). In terms of market share, Al Rahji dominates the Islamic banking segment with a loan book of $49.8bn at the close of 2013, the second largest of the entire banking sector. The sharia-compliant segment is also relatively efficient in comparison to the non-Islamic lenders. According to AlJazira Capital, the aggregate net interest margin (NIM) of Islamic banks stood at 4.1% in 2012, compared to 2.9% for conventional lenders, while the cost of funds for the nation’s sharia-compliant lenders averages out at 0.3% compared to 0.6% in the conventional sector. This cheaper funding can be ascribed to a larger amount of demand deposits held by Islamic institutions relative to the banking sector as a whole – term deposits being of little interest to those who deposit money with shariacompliant institutions due to the fact that the payment of interest is prohibited by Islamic law.

INSURANCE: The emergence of a sharia-compliant insurance sector is a relatively new phenomenon in Saudi Arabia. For centuries the concept of insurance was held to contravene a number of the precepts of sharia, including riba (usury, or interest), gharar (uncertainty) and maisir (games of chance, or gambling). However, in 1977 the Kingdom’s Council of Senior Ulema (a national body of religious scholars) declared that sharia-compliant coverage would be permitted in country for the first time, and the modern era of insurance got under way. Rather than deploy one of the various forms of takaful insurance that have met with considerable success elsewhere in the region, the Kingdom has formulated its own “cooperative” model, which differs from takaful in a number of small, yet significant, ways: although it is based on the principles of sharia and is often categorised as takaful in global surveys such as the “World Takaful Report”, the cooperative model does not demand a complete separation of policyholder funds and shareholder funds, nor does it compel insurers to invest only in instruments that are compatible with sharia, or demand the creation of sharia boards for individual insurance companies.

During the early years of its development, the Saudi insurance market was dominated by the stateowned National Company for Cooperative Insurance (NCCI), but the promulgation of the Law on Supervision of Cooperative Insurance Companies in 2003 broadened participation in the newly formalised sector. According to SAMA, 33 insurers are currently licensed in the Saudi market, all of which operate according to the nation’s sharia-compliant cooperative model. This makes for a crowded sector, and competition for market share is intense and played out largely in the arena of premium price. Nevertheless, the full-year 2013 financial results show that just three companies dominate the market in terms of their take of gross written premiums (GWPs): Tawuniya, which claims a market share of 22.8%, Medgulf (16.8%) and BUPA Arabia (12.9%). The remaining firms claim less than 5% of the market each, with 24 of the Kingdom’s insurers taking in premiums of under 3% of the sector’s GWPs.

SECTOR RATIONALISATION: The sharia-compliant insurance sector has increased its aggregate premiums take over recent years, but in 2013 many of its participants posted negative results in terms of profits – largely due to intense price competition. Some insurers sought to increase their premiums by taking on business at technically insupportable levels, with deleterious consequences for the sector’s health. Seven firms lost more than 50% of their capital over the past year as a result of poor technical performance, which in turn will make it impossible under the current regulatory structure to book additional business until their capital levels are restored. The obvious solution here is sector consolidation. However, the reluctance of family-owned insurers to cede control of their business and the troubled financial state of many of the smaller insurers mean that while mergers and acquisitions have long been discussed, so far there have been few concrete developments. Therefore, while many in the industry believe that a period of consolidation is now inevitable, when it will actually happen is as yet unclear. In the shorter term, those companies that have suffered severe capital losses and are unable to secure a willing buyer face the challenge of achieving recapitalisation through other means, such as a credit facility, or being required to wind down their business (see Insurance chapter).

SUKUKS: Another area of the IFS arena where Saudi Arabia is a regional leader is in the issuing of sukuks. Unlike conventional bonds, sukuks pay returns based on asset values and avoid riba by using separate sales and purchase agreements. The nation’s corporates and some government-related entities have been accumulating capital using one of the various forms of sukuk since 2004, and recent years have seen the frequency of Saudi issuances rapidly increase. In 2012 the nation issued $10.5bn worth of sukuks to become the largest issuer in the region, and the second largest in the world behind Malaysia. It retained its regional and global rankings in 2013 by issuing sukuks worth $14.5bn, according to Ernst & Young, distributed over 20 separate offerings. A number of factors underpin the continued interest in sukuks as a means of raising capital: a low interest rate environment, high liquidity in the investment segment and increasing state spending in recent years – all of which have played a part in propelling the instrument into the mainstream.

On the issuance side, the sovereign has played a part in sukuk growth with issuances that, although small in number, have provided significant impetus to the market and set a benchmark for other participants to scale their offerings. The $4bn, 10-year offering carried out in 2012 by the General Authority of Civil Aviation (GACA) is one such example, with the capital raised used to finance the expansion of King Abdulaziz International Airport in Jeddah.

Banks have also played a leading role in the development of sukuks, with most of the major industry players having made issuances or announced their intention to do so in the near future. Corporates, too, have entered the market with increasing regularity, and, according to a recent report by Saudi Hollandi Capital, there has been a steady rise in the number of project management-related offerings, such as the 2013 offering of $2bn by Sadara (a joint venture between Saudi Aramco and Dow Chemical), the proceeds of which will finance the company’s new Sadara Petrochemical project.

A DIVERSE RANGE: The sukuks issued in 2013 came from diverse segments, including the financial services sector, the food and beverage industry, construction and real estate, industrial manufacturing, and the power and utilities sector, demonstrating the ubiquity the instrument now enjoys. On the investor side, interest has come from equally disparate groupings. Pension and wealth funds are frequent buyers, particularly of the issuances with longer terms, as are the nation’s banks, which as a result of investment criteria aligned with Basel II and III typically opt for rated offerings. Shorter-term sukuks have proved popular with investment funds, thanks to their more liquid nature, and insurance companies, although usually limited by strict investment criteria set by the regulator, have been enthusiastic participants. Sukuks also represent a useful investment opportunity for corporates with excess cash and high-net-worth individuals looking for low-risk yields.

The growth in both demand and supply of sharia-compliant investment bodes well for the future of sukuks (see analysis), but the market is at an early stage of development and for now is almost entirely built on primary issuances. The Tadawul, Saudi Arabia’s stock exchange, launched an electronic trading platform for bonds and sukuks in 2009, and by 2013 this market consisted of eight listings, with maturities ranging from 2015 to 2025. While the Tadawul’s sukuk index lists instruments from some of the most prominent local institutions, such as the Saudi Electricity Company and Saudi International Petrochemical Company, the creation of an actively traded secondary market remains in its early stages, with the vast majority of activity in the bond and sukuk arena taking place on an off-exchange basis.

OUTLOOK: The Kingdom’s IFS sector is an important component of an international sharia-compliant industry that has succeeded in maintaining steady growth even in the face of a global economic downturn: according to Ernst & Young, total Islamic finance assets in Saudi Arabia grew by 19% annually between 2007 and 2012, with demand for instruments such as sukuks expected to outpace global supply as the sector continues to mature. The nation’s Islamic banks stand to benefit from a relatively underbanked population, with data from Bloomberg and AlJazira Capital showing that banking deposits in Saudi Arabia stand at around 46% of GDP compared to 89% in the UAE and 127% in Bahrain, as well as an increasing demand from corporates for sharia-compliant instruments. Although some insurers face challenges in the short term, the longer-term prospects of the sector are good, and well-established players are already starting to look beyond the easy growth of the mandatory lines, such as health and motor cover, to widen the scope of their coverage. While the sharia-compliant cooperative insurance model remains the standard for the industry, insurers expanding into the retail segment are likely to stress their adherence to Islamic law by establishing sharia boards and branding themselves as takaful firms.