Takaful Insurance At Crossroad

Steven Dewhurst, partner at DAC Beachcroft, suggests some regulatory action is needed to help tighten up the takaful market.

The Inland Revenue and Stamp Duty Legislation (Alternative Bond Schemes) (Amendment) Ordinance is not the flashiest title you could give a new piece of legislation, so it is perhaps understandable that its arrival in Hong Kong went largely unnoticed outside of the territory. Yet this obscure law, which puts the taxation of sukuk (Islamic bonds) on a level footing with conventional bonds in Hong Kong, marks a significant effort by the Hong Kong Government to promote the development of a sukuk market in the territory.

Hong Kong is not alone in seeking to position itself as a centre for Islamic finance. Stellar growth rates (albeit from a low base) have led to jurisdictions jostling for regional or global prominence.

Behind the hype, however, a more complex picture emerges. Last year's decision by HSBC Amanah to scale back its Islamic finance operations points to stellar growth rates failing to translate into a viable commercial proposition (in HSBC's case, the challenge lay in some markets being considered too small to justify continued operations). The point is that success in developing a market for Islamic finance is not just about regulation and tax. Most importantly, it is about ethics, in the form of Shariah compliance.

Banking dominance
Islamic finance continues to be dominated by banking. Insurance (takaful) has received much less attention and its development reflects a degree of neglect. Even in Malaysia, which has the most advanced system of takaful regulation in Asia (if not the world), the picture that exists is one of selective compliance with Shariah principles, aided by ineffective enforcement. Malaysian takaful is at a crossroads, however; a new Islamic Financial Services Act came into effect on 30 June 2013, introducing new provisions dealing specifically with Shari'ah compliance.

The interesting thing about Shariah compliance is that, like corporate governance, it embraces all aspects of a financial institution's commercial activities. We cannot (and should not) look at takaful as simply an alternative product which is sold to Muslims. Unlike conventional insurance, takaful is first and foremost an ethical proposition, not just a product. This explains why Malaysia's new Islamic Financial Services Act imposes a duty (backed by criminal penalties, no less) for takaful operators to ensure that all aspects of their commercial activities are Shariah compliant.

Takaful operators in Malaysia will surely struggle to satisfy this duty when it comes to looking at product integrity.

Spot the difference
The problem lies in the widespread use of takaful and retakaful contracts which are nothing more than conventional insurance and reinsurance contracts, "re-engineered" by replacing "insured" with "participant" and "premium" with "contribution" (to name two examples). The resulting products are fundamentally at odds with Shariah principles. The scale of this problem implies that it is simply a matter of time before Bank Negara singles out a takaful operator for enforcement, in order to encourage others.

Once it does so, Malaysia will cement its position as a leading global centre for Islamic finance, and its competitors will recognise the primary importance of creating and enforcing a strong ethical framework within which Islamic finance can thrive.