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Opalesque Islamic Finance Intelligence

Industry Snapshot: Alignment of Corporate Governance and Company Performance: A Focus on Takaful Omar Clark Fisher PhD

Friday, July 30, 2010

Dr. Fisher has extensive industry experience spanning over 15 years, which include leading the investment banking team that launched t'azur company; Managing Director, Takaful Business Development at Unicorn Investment Bank; as well Deputy Head Takaful Division at Bank Al-Jazira. He is a frequent presenter at internationally-recognized trade and insurance industry conferences and is the author of numerous articles on Islamic finance, leasing and Takaful (including three books). Omar holds a PhD Management Philosophy-Takaful, a joint degree conferred by International Islamic University of Malaysia and Camden University.

Corporate Governance and Company Performance

From Board rooms, to regulators' offices, to stock exchange trading floors the global debate marches on: does good corporate governance enhance stock prices and/or shareholder value?
While research studies are by no means conclusive, evidence is mounting up that "better corporate governance leads to better future financial and stock performance"1. According to the Policy Brief published by the Hawkamah Institute, "In its September 2005 report, 'The Irresistible Case for Corporate Governance,' the International Finance Corporation (IFC) asserts that sound corporate governance increases company valuations by 20-30% in developing markets and leads to higher credit ratings and a corresponding improvement in access to finance."2

A Wilshire Report in July 2009 documented statistically the positive impact of good corporate governance on share prices of 139 public companies that the California Public Employees' Retirement System (CalPERS) invested in beginning in 1987 and thereafter insisted they adopt corporate governance policies and best practices. Compared to a benchmark return on cumulative basis, average companies invested into by CalPERS yielded 3% per annum higher, or a 5 year excess return of 15.3%3. Significantly, Wilshire found that institutional investment by CalPERS and the updgrading of corporate governance led within one year to "targeted poorly performing companies to underperform by only 1.5% vs. a massive 23.6% underperformance just one year prior." 4

Another finding of the Hawkamah Institute is that: "Shari'a compliant insurance companies need to explain clearly the relationship between the policyholders' fund and the operating company. In particular, shareholders need to know what their obligations will be to support the policyholders' fund in the event that the fund faces financial difficulties. Disclosure should focus on the legal relationship between the two entities, and also disclose any regulations to which the takaful firm is subject, which may affect the flow of funds between the two entities."

Dr. John Lee, Executive Director, KPMG commented in June 2009 on Exposure Draft No. 8 from International Financial Services Board (IFSB) of Malaysia regarding corporate governance for Takaful
companies: "Because of structure of Islamic finance, the need for transparency is even greater than perhaps in conventional. The fact that participants have a direct stake in some of these transactions, I think that's why there's so much emphasis on the need for transparency. So who's looking after the interests of policyholders? Some would argue that perhaps it's the Shari'a board... but a lot of the role of the Shari'a board has been confined to product development areas as opposed to looking at broader issues such as fairness to policyholders."

Although worldwide there are four variations of the basic system of Takaful, the Islamic alternative to conventional insurance, common elements are apparent. Succinctly put, these are:

  •  Insureds make contributions (often called "tabar'ru or donations) rather then pay premiums
  •  Core essence is mutual assistance to needy members of the group (or ta'awun)
  •  Risk-sharing among members (form of joint indemnification) rather than risk transfer
  •  Avoidance of prohibited elements such as al maisir (form of gambling), al gharar (uncertainty and deception) and al riba (interest or forbidden types of commercial gain)
  •  Separation of ownership interests of policyholders (members) from shareholders
  •  Use of Shari'a compliant agreements in all activities - including investment of contributions and share capital
  •  Excess funds resulting from annual operations - called Surplus not profits - legally belongs solely to policyholders (who after all contributed the risk capital) and not to shareholders, as is featured by stock insurance companies. Based upon the above, lets examine five (5) observations that arise.

    Misalignment of Shareholders' and Policyholders' Interest

    With one exception5, the Takaful models employ an organizational structure whereby shareholders assert themselves as "agents" for the policyholders through Mudareb or Wakala arrangements. This arrangement is typically legitimized by the voluntary purchase by the policyholder/member of a Takaful Operator's policy. However, many Takaful policies are frankly oblique in terms and conditions, and may not fully disclose rights, responsibilities and fees attendant to this arrangement. Hence, the first important observation is the rights, responsibilities and role of policyholders are not always clearly set forth and readily disclosed in ads, brochures, web sites, let alone in actual policy wordings. Common practice under good corporate governance requires that customers (read policyholders/members) be provided clear, unambiguous and easily accessible descriptions of rights, responsibilities and other consumer protection disclosures, today circumscribed by normal business practices-especially in financial services. No doubt in reaction to the recent global financial crisis (2007-2009), regulators and insurance practitioners alike are giving more attention to transparency and disclosures.

    Secondly, nearly all Takaful Operators establish themselves as managers of the risk pool with no consultation with policyholders-the main beneficiaries of that risk pool. Of the various policies the author has read, not one specifies how policyholders can appoint management or even remove management. It seems their sole recourse is to lapse their policy, or to terminate the policy early if aggrieved or somehow poorly represented by their "agent", the Takaful Operator. Again, good corporate governance practices amongst stock companies generally (including insurance) sets forth the manner in which customers (read policyholders) can complain, influence business management or in extreme cases, mount an appeal to the Board via a proxy campaign or via legal recourse called "class action suit" to impress upon management its grievances.

    Thirdly, on a slightly more technical point, the calculation of Surplus at year end is conducted by shareholders only through management with no consultation (again) with policyholders. The decision about retaining Surplus, adding to Reserves or size and timing of Distribution of funds is totally determined by the Takaful Operator. Some industry experts take comfort in the Sharia Supervisory Board's oversight of Takaful business operations, which does include this issue of Surplus calculation. Nonetheless, Surplus is right of policyholders who have contributed that risk capital to the Takaful pool. Good corporate governance should dictate that policyholders be actively involved in such calculation and decision-making, rather than resort to a "watch-dog" status for scholars or discovery through a Shari'a audit, which is still not a regular and respected fixture of Takaful operations globally.

    Fourthly, a survey of Takaful companies around the globe will demonstrate that so far the Board of Directors represents solely the shareholder's interests. Many boards do not yet have even independent board members (ISAS recommends 1-3), nor any representatives from policyholders6. Fifth and finally, despite the importance of policyholder capital (in the forms of annual contributions as well as accumulated reserves) in addition to shareholder capital (albeit not at direct risk to claims payments), Takaful companies typically are not involving policyholders in either investment decision-making neither in major decisions such as mergers, acquisitions or divestment of large assets. Again, these decisions significantly influence the financial strength of the Takaful yet occur at the Board level with no consultation or inputs from the Takaful's constituency-the policyholders. By contrast as shown in the descriptive table below, mutual insurers dare not resolve such decisions at the Board level alone, and usually consult policyholders via a referendum, survey or even proxy voting.

    Comparative Roles of Policyholders

    Intuitively, people feel safer in a group. Most people will opt for the security, relative safety and economic benefits to themselves at mutual risk-sharing. Indeed, mutual risk sharing in the modern day bears a striking resemblance to the ancient Arab tribal practices. However, upon closer examination there are important differences, as are shown in the table below:


Guidance from IAIS and IFBS on Corporate Governance

IAIS guidelines and IFBS recommendations on good corporate governance for Islamic insurance companies may be summarized:
1. Clear roles and responsibilities for

  •  Board
  •  Board Committees - remuneration, investment, risk management, audit and perhaps Corp Governance Implementation
  •  Senior management- job descriptions; Lines of authority; authority matrix
  •  Shari'a Supervisory Board - how appointed; how removed
  •  Auditors - both internal and external audit; who conducts a Shari'ah audit
  •  Policyholders - what are PH rights; obligations; how to terminate a policy; how to lodge a complaint; or appeal a complaints resolution
  • 2. Clear pathway to resolve conflicts and disputes - explain the treatment of complaints
    3. Verification of compliance - adhere to U/W guidelines; financial reporting; regulatory; Shari'a; investments compliance
    4. Adopt Code of Ethics for business and conduct of personnel - both operations and sales staff; how does the Code extend to 3rd parties like banks, brokers, other intermediaries; how to enforce compliance

Essential Elements in Takaful Corporate Governance

We may conclude, therefore, that essential elements of good corporate governance for a Takaful operations would incorporate the following items:

  •  Be consistent with Takaful risk sharing model (congruent with Takaful business principles)
  •  Existence of Ethics Code for business operations and binding on personnel
  •  A fair balance of Shareholder (SH) interests and Policyholder (PH) interests
  •  Encourage policyholder representation and, where possible, participation in management decision-making in matters of direct impact to policyholders
  •  Market discipline imposed through disclosures and financial reporting
  •  A goal to manage the business to be self-sustaining, fulfilling solvency requirements (in compliance with insurance regulations of that jurisdiction) rather than maximizing profits for only the Shareholders

 Pursue sound investment strategies (matching assets/liabilities, sound liquidity, safety and diversification) in accordance with Shari'a compliant rules

Given the above discussion, the author humbly suggests that an additional core principle be included into the definition of what makes a Takaful:

  • Tabar'ru - contributions from members or policyholders are donation
  •  Ta'awun - mutual assistance extended from the group risk pool
  •  Prohibition of riba and other impermissible commercial elements- in both Shareholder capital and Policyholder common funds
  •  Surplus excess funds at year end legally belongs solely to Policyholders
  •  (added) "Voice" and participation by Policyholders in Takaful operations


Moving Forward - The Major Challenges

As Takaful companies enter only their 4th decade of existence, as contrasted with conventional insurers whose longevity exceeds 400 years, one may assert that formidable challenges lie ahead in execution of good corporate governance; namely:

1. Balancing the conflicting responsibilities and interests of Shareholders/Policyholders within the hybrid Takaful model as to:

  • Capital adequacy
  •  Risk management
  •  Transparency
  •  Market discipline/disclosures
  • Financial returns (dividends vs. surplus refunds)

This is because financial objectives are generally not aligned, consequently Surplus enhancing activities quite often reduce the final profits to Shareholders and potential for dividend payouts.

2. When Takafuls conduct cross-border transactions or open branches or joint ventures to expand horizons, there looms large the challenge of balancing various Shari'a issues of differing Takaful models, variations in product implementation, styles of risk management, lack of range of investment vehicles and even identifying and appointing local, qualified Shari'a scholars to advise the company. In addition, often poor/no audits occur on actual compliance within the Takaful to Shari'a principles espoused during business operations.

3. What "voice" - if any - to provide Policyholders in operations. To date, the author is unaware of any Takaful operator that gives an active role to Policyholders. Among the potential roles-representation on the Board of Directors (non-voting), representation on the Executive Operations Committee (observer status), representation on Committees of the Board or Executive Management, are some examples.

Other open areas for research are:

  • What is proper mechanism to appoint a Takaful Operator (TO), or to dismiss a TO by Policyholders?
  •  Information asymmetry - ie TO has all data, and develops all financial statements whereas the Policyholder has no access to data and no role in financial decision-making
  •  Misalignment of incentives - Shareholders through the CEO they appoint set the rates, dividends and surplus policies without inputs from Policyholders. Note that some TOs charge their expenses and fees to the Policyholders' risk pool and also demand an Incentive bonus. (ie what's left for PHs?)
  •  Inherent Conflicts of Interest - in those circumstances where Shareholders make all business decisions, which gives rise to potential for a Conflicts of Duties - Shareholders serving own aims over those of PHs


Data compiled by global Takaful reports make clear that the nascent industry is growing rapidly - more than 25% per annum in some countries - and outstripping the growth of conventional insurance. Although, global Takaful contributions amount to less than 1 percent of insurance industry annual premiums of $4 Trillion dollars (2009), both the impressive rates of adoption of Takaful coverages and the proliferation of new Takaful entities assure that this segment of the industry will swell in breadth and importance. Eventually by capturing just 1% of global risk coverages, the Takaful volumes of contributions can reach $40 Billion annually worldwide, which would position Takaful alongside cooperative and mutual insurance as a truly global player and risk protection mechanism of choice for millions of policyholders. Thus, implementation by Takafuls of good corporate governance equally fair to shareholders and policyholders most assuredly will propel enduring growth for this sector.


1 Stanford Professors working paper (2008) as reported by Eric Jackson, "Does Corporate Governance Impact Performance", July 2009.
2 Hawkamah Institute for Corporate Governance, Policy Brief, March 2009
3 Wilshire Report, "The CalPERS Effect- on Targeted Company Share Prices", July 31, 2009.
4 IBID, p. 4.
5 In Sudan, the original home to rediscovered Takaful (1979), several of the cooperative risk pools do not have shareholder capital and hence like mutuals appoint management from amongst members.

6 Excluding those standing Board members who coincidentally may also own a Takaful policy issued by their company.

Your feedback and comments are very important to us, please feel free to contact the author via email.

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