For : PROF. DATO DR.

KAMARUDDIN SHARIF
By: NOORHAYATI MAAMOR - ZP00767 ZUBYDAH HAMZAH ZP00708

10.1 10.2 10.3 10.4

Introduction The Need For Solvency The Principle of Solvency Traditional Approaches to Insurance Solvency 10.5 Risk-Based Capital Malaysian context

Ratios Method

RiskBased Method

One form of prudential

regulation aimed at ensuring that regulated entities operate safely and soundly. Includes requirements for minimum risk management standards, requirements for fitness and propriety of managers and owners, and

requirements for sensitivity

analysis to forecast the effect of plausible scenarios

Solvency requirement is a key regulatory tool in contemporary Takaful regulation, especially in view of the increasing complexities of Takaful business and operations.

Ratio-based Approaches:-

Solvency margins calculated on the Assessment of the capital adequacy basis of ratios of premiums, claim of individual insurers on a riskand liabilities adjusted based (in analogy to Basel II) relatively easy to handle; requirements vary with level of business; arbitrary values; usually identical treatment of different classes of business; various forms of risk not captured (exchanged rate, market fluctuation, etc); no consideration of individual cases. technically much more demanding; expensive experts required; classification of capital into two or more tier of different quality; identification of different risk classes; capital requirement based on defined probability of failure; use of internal risk model or of a standard model.

Risk-based Approaches:-

THE NEED FOR SOLVENCY REQUIREMENTS

1. To increase the likelihood that a Takaful undertaking would be able to meet all its contractual obligations and commitments;

2. To act as an early warning system for regulatory intervention and immediate corrective action, taking into account that the supervisory authority may sometimes have access only to incomplete information, and that even corrective actions may take time to generate the desired impact; 3. To provide a buffer so that even if the Takaful participants are to suffer a loss in the event of failure of a Takaful undertaking, the impact can be limited or reduced; and 4. To foster confidence amongst the general public, in particular Takaful participants, in the financial stability of the Takaful sector

THE PRINCIPLE OF SOLVENCY

1. Assets and liabilities are measured according to prescribed valuation rules; examples it is likely that some assets would be excluded or revalue downwards for solvency purposes, reducing the amount of surplus available and the true regulatory surplus would be only the amount by which the available excess of assets over liabilities exceeded the required margin of solvency or regulatory capital requirement.

Relationship between shareholder surplus and regulatory surplus The view for shareholders.
Assets Regulatory capital Shareholders equity Liabilities Liabilities

..and for the regulator

Regulatory surplus Regulatory capital requirement Valuation adjustments

2.

Continuous requirement.

TRADITIONAL APPROACHES TO INSURANCE SOLVENCY

Minimum paid-up capital requirements Required minimum solvency margins
Insensitive toward the capital an institution required for its business Motor damage predictable Others losses are large ie latent diseases or environmental pollution

Ratios to premiums, claims or liabilities ie 20% If based on premiums, extra risk takers subjected to lower solvency requirements Does not capture other risks ie exchange rate, credit risks, market risks.

Takaful an obvious example, as its investment universe is limited

TRADITIONAL APPROACHES TO INSURANCE SOLVENCY

Life insurance

Great reliance on conservative judgment of actuaries Now, greater role valuation of liabilities

Solvency reqs complicated protection and savings element

Takaful

IAIS/IFSB note that in light of the specific structure of takaful operator, modifications is required

RISK-BASED CAPITAL
Used by rating agencies ie S&Ps, AM Best, Moodys and Fitch Ratings depend on capital adequacy on riskadjusted basis

Basel Accords
Classification of capital into tiers of different quality
Consistent rules on assets and liabilities calculation Identification of different classes of risks Setting of capital requirements based on prob. Of failure

Internally developed capital models

Regulators active role in risk assessments

DIFFICULTIES OF RISK-BASED CAPITAL IMPLEMENTATION

Skilled resources

Creation and assessment of models

Insurers operates in tight margins

Spending money in capital models

Dominated by large no. of small companies

Intense & inefficient competition

THE NATURE OF CAPITAL FOR TAKAFUL

Qard hassan asset and liability cancel out

Takaful Model allows for capital to be contributed to the risk fund in the form of

qard hassan

Risk fund

Qard

Deficit

Qard
Liabilities

Liabilities Liabilities

Operators fund

Risk fund

Operators fund

Regulatory Regulatory Capital Capital

Combined

Operators fund Risk fund

Assets Assets

Assets Assets

Takaful Operator may consider:

Capital in the operators fund that is available for transfer as qard hassan but has not actually been transferred Calls on participants for additional contributions

Resolutions of BNMs SAC

In the event that the reserves are not sufficient to cover deficits in the Participants Special Account (PSA), then the takaful operator must cover the deficits by giving financial help from the shareholders fund by way of qard hasan. (38th Meeting) SAC approved the Central Bank of Malaysias proposal to impose on the takaful operators the responsibility for the solvency of takaful funds and to secure the benefits and savings of the participants through asset injection from the shareholders funds into the takaful funds to cover any deficit that occurs based on the reason given. The security and injection of asset may be implemented by the takaful operator based on commitment to donate (iltizam bit tabarru`), i.e., the operator undertakes to give donation to cover all the claims (liabilities) on the takaful fund in the case of deficit. (46th Meeting)

Source: BNM

Different tiers of capital

The Basel Committee convention capital is divided into tiers of quality Top quality paid-up share capital plus premiums, plus cumulative retained earnings Low quality preference shares and subordinated debt instruments, for takaful, potential qard hassan and the ability to make calls

Solvency Requirements Categorization of Risks by IAIS (International Association of Insurance Supervisors)

Premiums charged inadequate to meet liabilities

Underwriting

Credit

Failures of counterparties to meet obligations For takaful, the risk that fees received are less Assets failing to realize values assigned than the management expenses Institution being solvent and unable to mobilize liquidity Inadequate or failed internal process, systems or people

Market

Liquidity

Operational

DISCUSSIONS

THE ROLE OF WAKALAH IN STRENGTHENING THE CAPITAL ADEQUACY & SOLVENCY OF TAKAFUL FUNDS
Under the wakalah contract, the contractual responsibilities of the takaful operator are as a trustee (amin) and not as a guarantor (kafil). The takaful operator is not responsible in the case of any loss of deficit in the takaful funds in the course of the takaful operation, unless such losses or deficits are caused by negligence or fraud of the operator. Therefore, it can be said that solvency is not the direct responsibility of the takaful operator, but rather that of the takaful fund or ultimately the takaful participants.

IMPOSITION OF DUTY TO GIVE FINANCIAL SUPPORT ON THE OPERATOR ?

The policy basis for imposing the responsibility for solvency on the operator reflects the current environment in takaful business, i.e.: Takaful operators are licensed Islamic financial institutions in a regulated industry; Takaful operators market their takaful products to the participants with the understanding that claims can be met from the takaful funds, and that they are expert in managing the funds; Takaful operators make profits from their duty and expertise in the management of the takaful funds, and this should include solvency valuation and management;

CROSS SUBSIDY BETWEEN VARIOUS TAKAFUL FUNDS?

The SAC disallowed the practice of using the surplus or reserves from one takaful fund to crosssubsidise the deficit in another takaful fund because: The risk profiles and nature of liabilities in each fund are different. The participants in each fund may not have agreed to take different or higher risk profiles into their scheme The original intent of the participants in the tabarru` contract is to be considered in determining whether crosssubsidy is intended to be covered by the fund or not If there is no express provision for crosssubsidy in the terms of the tabarru`, then crosssubsidy is not allowed, because the participants are understood to intend to provide only for those with similar risk profile in their scheme only.

CROSS SUBSIDY BETWEEN VARIOUS TAKAFUL FUNDS?

Another mechanism to overcome the problem of deficits in takaful funds that is being considered by some takaful operators or perhaps the regulator is the practice of crosssubsidy between various takaful funds. In this mechanism, the surplus or available reserve of a type of takaful fund / scheme will be used to cover any deficit in another takaful fund / scheme under the management of the takaful operator. The idea is, to try to cover the deficit from the participants tabarru funds first, regardless of the type of fund or its risk profile, before resorting to the injection of asset or fund from the operator by way of qard.

ENHANCED SOLVENCY FRAMEWORK FOR TAKAFUL

Source : Global Islamic Finance Forum 2010

THE END