Operational and Actuarial Aspects of TakafulRetakaful

Sub TopicsBasic PrinciplesRetention CapacityClasses of RetakafulRetakaful v ReinsuranceCertificate IssuanceMethodology

IntroductionAdverse Claims experience is

influenced by:Major losses of the individual risksMajor losses arising from a single eventHigh frequency of many small lossesChange in risk structure (technological,

economic, social and political)

Elements of ReinsuranceReinsurance is a type of insurance but is a

distinct and separate contract from the original insurance and itself takes the form of a contract of insurance.

Reinsurance may cover part of the ceding company’s portion, but no more than that.

The reinsurance contract must cover the same risk as the original insurance.

Both insurance and reinsurance policies are to be in existence at the same time.

Elements of ReinsuranceThe co-existence rule seems to have been

dispensed as decided in General Accident Fire and Life Assurance v. Tanter, The Zephyr (1984), where the reinsurance had been placed before the insurance. In both practice and law, The Zephyr confirms that an undertaking to indemnify against future liability is coherent with the objectives of reinsurance.

Basic PrinciplesSame as insurance; namely Indemnity,

Utmost Good Faith, Insurable Interest, Subrogation, Contribution and Proximate Cause.

In particular, the 3 principles apply directly in the case of reinsurance; Indemnity, Utmost Good Faith and Insurable Interest.

IndemnityPutting the insured in the same financial

position as he/she was, before the insured event.

The real limit of indemnity is the extent of the cedant’s insurable interest.

The amount recoverable from reinsurance relates to the corollary of indemnity, which is the average clause

Why RetakafulRisk spreadingCapacity boostingFinancial advantageFinancial stabilityProtection against catastrophic risks

RetentionDefined as “the limit of liability, usually

expressed as a monetary amount, which the insurer retains for its net account after reinsurance”.

Also be defined as “the maximum amount that the insurer is willing to pay for a loss affecting a policy, risk or group of risks".

The retention may apply to a single risk or a series of risks, or to a single loss or series of losses.

RetentionRetentions are usually fixed based on each class of

business separately (family, fire, accident, marine, aviation, etc.).

There may also be an overall retention over the combined portfolios of the various classes.

There is only an optimal retention for each takaful operator. The optimal retention will provide the takaful operator a framework in which to achieve its particular corporate objectives.

Takaful operators with similar portfolios but having different corporate aims will likely to have different retention levels.

Retention The factors for consideration:1. Size of the operator2. Contribution income, size of portfolio and

profitability3. Financial strength of the operator4. Reinsurance/retakaful type and cost5. Claims experience6. Corporate strategy

Classes of Retakaful/Reinsurance Treaty

Proportional1. quota-share2. surplus (above retention limits)3. facultative obligatory

Non-proportional 1. excess of loss2. stop loss3. Catastrophe loss

Classes of Retakaful/ReinsuranceFacultative (individual basis)

Proportional1. quota-share2. surplus

Non-proportional1. excess of loss

Financial Re - focused more on capital management than on risk transfer.

Captive Re

TreatySufficient flow of retakafulThe primary consideration that the portfolio

may be exposed to large individual losses More convenient as all risks accepted by the

ceding operator requiring retakaful falling within the scope of contract will be automatically covered.

Treaty – Which Type? Factors to consider :1. Type of coverage2. Administrative costs & ease of operation3. The effect on net retained premium

income4. Whether to control exposures or ease

the financing of solvency5. Whether to engage in reciprocal

business

Treaty – Pro or Non Pro?Proportional

A surplus treaty is technically the best arrangement to deal with large individual risks on classes of business with fixed sums covered and the ceding operator can retain part of the biz

However, a surplus treaty requires considerable amount of skill and time in its administration, and as such may induce a ceding operator to place retakaful on a risk excess of loss basis.

A quota share treaty usually will carry a higher rate of retakaful commission than a surplus treaty.

Treaty – Pro or Non Pro?Non Proportional

Excess of loss & quota share treaties are much cheaper and easier to operate

For added stability, stop loss retakaful may be considered for the protection of classes of takaful exposed to large-scale fluctuations in aggregate annual claims.

Facultative Generally, facultative placement is necessary in the

following circumstances:

1. The risk falls outside the ceding operator’s treaties, such as outside geographical area or an excluded class of risk

2. The sum covered exceeds the treaty limit3. The ceding operator does not want to cede the risk to the

treaty4. The risk is unattractive to be offered on a treaty basis5. The takaful operator wishes to accommodate a special

case that may fall outside the scope or limits of its treaties6. The takaful operator does it for unique commercial,

financial or strategic reasons

Facultative - AdvantagesRisks are considered individually;It increases the takaful operator’s

competitive edge in that particular line;There is freedom to offer any risk which

may be accepted or declined;A particular account may be further

protected by use of facultative retakaful Transfer of knowledge and technology

Facultative - Disadvantages The takaful operator may not be able to

place the risk The process is more complicated and

involves more administration There could be errors in placement Cover cannot be confirmed until placement

is effected

How much to Reinsure?Proportional

Quota shareSurplus treaty

Non ProportionalExcess of LossStop Loss

Quota ShareA company may only be able to offer $1

million in coverage, but by purchasing proportional reinsurance it might double or triple that limit. Premiums and losses are then shared on a pro rata basis.

For example, an insurance company might purchase a 50% quota share treaty; in this case they would share half of all premium and losses with the reinsurer. In a 75% quota share, they would share (cede) 3/4 of all premiums and losses.

Quota ShareAdvantages

the relationship between cedant and the reinsurer/retakaful operator is absolute - in such a context the reinsurer/retakaful operator follows the fortunes of the cedant almost identically

the accounting and reporting of business is simple

flexibility exists in increasing or decreasing the amount of quota share ceded; i.e. the cedant may vary the quota share

unlimited cover is provided for aggregation of risk losses in a single loss event

Quota ShareDisadvantages

since a quota share involves the cession of all business within the retention pattern, large amounts of income are ceded away - this could be to the detriment of the cedant

a quota share treaty is inflexible as the cedant has no choice in selecting a retention limit.

Quota ShareA quota share treaty is more appropriate new

takaful operators, or developing a new line or class of business, or for experimental or special where the reinsurer/retakaful operators' expertise is needed

Surplus TreatyThe operator transfer the amount of risk above

its retention limit (defined as a ‘line’). Retakaful operator will accept the part of every risk that exceeds the operator’s retention limit automatically. The latter shares in contributions and losses in the same proportion as it shares in the total limits of the risk.

E.g. An operator issues a cert for $20,000. It keeps $5000 (¼) and transfers the remaining $15,000 (¼) to its Retakaful. This is called a three line surplus because the amount transferred equals three times the retained line of the operator. It keeps ¼ and transfers ¾ of the contribution to the Retakaful.

Surplus TreatyIn the event of total loss, the settlements between

the two operators would be effected on the identical ¼-¾ basis. If there is a partial loss, the Retakaful must reimburse the operator in the same proportion as the reinsurance contribution received.

E.g. In a 9 line surplus treaty where retention limit is $100,000 the reinsurer would accept up to $900,000 (9 lines). So if the insurance company issues a policy for $100,000, they would keep all of the premiums and losses from that policy. If they issue a $200,000 policy, they would cede half of the premiums and losses to the reinsurer (1 line each). The maximum underwriting capacity of the cedant would be $ 1,000,000 in this example.

Surplus TreatyThe larger the number of lines, the higher the retakaful

operators obligation

It reduces the retained loss cost on larger risks and limit the loss on any one risk. It provides the cedant a larger retained contribution for the same retention limit on any one risk, therefore providing better balance.

Main purpose is to attain automatic underwriting capacity to enable the cedant to transact business in its chosen market and compete with its peer operators.

Surplus treaties are also known as variable quota shares.

Surplus TreatyAdvantages:

a surplus treaty allows the operator to vary its retention upon a particular risk;

there is automatic capacity available upon a particular class and size of risk;

the operator is allowed to retain a greater proportion of its income – this aspect would be diluted if the cedant chose to effect any quota share reinsurance/retakaful on all or selected parts of its account.

Surplus TreatyDisadvantages:

the operator stands or falls by its chosen retention - this is a fundamental calculation for the cedant

comparison of results between the cedant's net results and those of its surplus reinsurer/retakaful operators might be different - whichever way they fall might influence the original construction between the cedant’s net and gross accounts and the benefit which the cedant should obtain from such arrangements.

Facultative Obligatoryis used for a substantial number of

individual facultative cessionsTreaty are concluded in advance and the

cedant has the option to cede risks to the treaty. The obligatory element rests with the reinsurer/retakaful operator, who must accept such cessions once they are made

Tend to generate small incomes for a large capacity

Facultative ObligatoryAdvantages

Provides the cedant flexibility and complements existing automatic treaty facilities, and such facilities follow the cedant's gross retention pattern.

The cedant also benefits from the knowledge that it should be offered a risk larger that its capacity,

Treaty would offer sufficient automatic underwriting capacity hence the cedant would not have to resort to the extensive administration required in making an individual facultative placement.

Excess of LossIt will either limit the individual retained

loss, or the accumulation of retained losses from one event, or the aggregation of retained losses over a period

The stop loss limits the total claims over a given period of time, normally on an annual basis.

Under aggregate excess of loss, it is normal if only individual claims in excess of a certain figure will be included in the deductible

Excess of Loss ExampleThe insurer is prepared retain a loss of $1

million for any loss which may occur and they purchase a layer of reinsurance of $4 million in excess of $1 million.

If a loss of $3 million occurs, the insurer pays the $3 million to the insured, and then recovers $2 million from its reinsurer(s).

Excess of LossExcess of loss reinsurance can have three

forms –Per Risk XL (Working XL) Per Occurrence or Per Event XL (Catastrophe

or Cat XL)Aggregate XL

Per Risk XLFor example, an insurance company might

insure commercial property risks with policy limits up to $10 million, and then buy per risk reinsurance of $5 million in excess of $5 million. In this case a loss of $6 million on that policy will result in the recovery of $1 million from the reinsurer.

Per Event XLFor example, an insurance company

issues homeowner's policies with limits of up to $500,000 and then buys catastrophe reinsurance of $22,000,000 in excess of $3,000,000. In that case, the insurance company would only recover from reinsurers in the event of multiple policy losses in one event (i.e., hurricane, earthquake, flood, etc.).

Aggregate XLCompany retains $1 million net any one

vessel, the cover $10 million in the aggregate excess $5 million in the aggregate would equate to 10 total losses in excess of 5 total losses (or more partial losses).

Aggregate covers can also be linked to the cedant's gross premium income during a 12 month period, with limit and deductible expressed as percentages and amounts. Known as "Stop Loss" or annual aggregate XL.

Retakaful v ReinsuranceReinsurance law derives largely from

English law whilst retakaful is based on the Shariah (the retakaful contract between takaful operator and the reinsurer/retakaful operator, must comply with Shariah).

The question now remains; which jurisdiction does it fall under, especially if reinsurer/retakaful operator is based in a foreign country),

Retakaful v ReinsuranceContracts between takaful operators and

reinsurers/retakaful operators just mirror exactly the conventional reinsurance contract (non shariah compliant)

Issue of profit commission or experience refund do not comply to shariah or follow the principles of takaful.

As for the solid financial standing and technical advisory services, retakaful operators themselves mostly retro-takaful to leading conventional reinsurer.

Retakaful v Reinsurance Retakaful with conventional reinsurer to be

subjected to the following conditions:1. The retakaful has not enough capacity 2. Arrangement should be of a temporary nature

and agreement should be reviewed periodically. 3. As far as possible, contract between the takaful

operator and the reinsurer should comply with Shariah.

4. Inward retakaful from insurers can only be accepted if it is conditional on outward retakaful subject to conditions (1) and (2).

Contracting of Retakaful Normal to use Brokers (in General Biz) whose

services include:1. As an adviser to help construct the program2. To identify the potential markets for the

business and the security of reinsurer/retakaful operators

3. Undertake the marketing & placement of the business

4. Prepare contract wordings5. As arbiter in the event of disputes arising6. Administer the program, including the collection

& transmission of contributions, and claims settlements

Challenges of Retakaful

New – sometimes no/low security ratingServices underdevelopedDifferent ModelsLack of Expertise – Shariah, Actuarial and

Underwriting

Pricing Considerations In pricing for non-proportional retakaful, both general and

family, retakaful operators must take the following factors into consideration :

Claims experienceOriginal underwriting limits of the cedantThe basis of these limitsNature of the accountEffect of inflationCurrency fluctuationsRisk profiles of the portfolio of businessCatastrophic perilsUnderlying protectionsAmount of coverRelationship with the cedantQuality of business

Financial Re'Financial reinsurance' were basically funded

whereby the reinsurer agreed to pay an agreed schedule of loss payments in the future in return for the ceding operator paying specified premiums based on the net present value of the loss payments.

Therefore, 'financial reinsurance' is not actually insurance contracts but falls under the ambit of banking contracts.

In this respect, authorities such as insurance regulators and tax authorities decided that these contracts do not qualify as insurance contracts as there was insufficient transfer of risk.

Financial ReFinite risk reinsurance will resemble traditional

insurance if the elements of both timing risk and finite risk are greater. Finite reinsurance contract should also have the following characteristics :Make explicit allowance in the price for investment

earnings;The cedant usually is allowed to share in any profit, but

conversely is required to contribute to any loss under the contract;

A limit is usually placed on the aggregate loss payable by the reinsurer operator.

May be arranged on either pre-funded (prospective) or post-funded (retrospective) basis.

Financial ReRetrospective covers - These address losses that

have arisen on contracts written in previous underwriting years. They include Loss Portfolio Transfer, Adverse Development and Retrospective Aggregate Excess of Loss covers.

Prospective covers - These address losses arising on business written in future years. They aim to smooth the results of future underwriting tears by mitigating serious increases in losses that may occur in the future. They include Finite Quota Share and Spread Loss treaties.

Financial ReThe Catastrophe Risk Exchange, also

known as CATEX, was established in 1996 in New York to enable insurers, reinsurers and intermediaries to trade tranches of insurance portfolio.

It is an online system that enables insurers and reinsurers exposed to catastrophic losses in one geographical area to trade part of it with others who are exposed in other areas. All Lloyds syndicates have access to the system.

Financial ReA Catastrophe Bond is a form of corporate bond where the

holder agree to forgo or defer the payment of interest and/or of principal if a defined loss event or experience occurs that exceeds a specified trigger.

Catastrophe Swaps are a series of fixed, pre-defined payments in exchanged for a series of floating payments whose values depend on the occurrence of an insured event.

An Industry Loss Warrant is similar but is structured as a reinsurance transaction, which is activated by a double trigger of both industry losses and losses incurred by the cedant, both exceeding pre-specified thresholds.

Financial ReFinite reinsurance recognized as an

appropriate form of risk transfer but there is concern whether they are properly accounted for in a manner that reflects economic reality.

Problems are when finite reinsurance is abused, such as when it is used as a "low cost loan that flies below the regulatory radar" and when its effect is to transform a company's income statement and balance sheet in a way that does not "reflect economic reality."

Reinsurance ReservingThe delay between the claim, intimation,

settlement and reporting dates necessitates that the retakaful operator set up "reserves" in respect of those claims still to be settled as in the case above.

The problems of loss reserving are further compounded by a persistent upward development of most claims reserves.

Reinsurance ReservingInherent problems:

Claims data are limited, particularly for retrocession business;

The numbers of claims and individual claims information are often not be available, particularly for proportional business.

It is difficult to develop a good loss development pattern as the data is heterogeneous and sub-dividing the data into too small groups, to improve homogeneity, can give rise to excessive volatility.

The development of claims data is generally medium/long-tailed

The length of tail also means that development factors to ultimate which too large and sensitive to be reliable especially in the early periods of development.

Different underlying currencies and inflation rates may distort aggregated data;