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       ISLAMIC FINANCIAL SERVICES BOARD

                   EXPOSURE DRAFT

STANDARD ON SOLVENCY REQUIREMENTS FOR

TAKĀFUL (ISLAMIC INSURANCE) UNDERTAKINGS

        Comments on this Exposure Draft should be sent

  to the IFSB’s Secretary-General not later than 15 05 2010

   at email ifsb_sec@ifsb.org or facsimile +603-26984280

                     December 2009


                ABOUT THE ISLAMIC FINANCIAL SERVICES BOARD (IFSB)

The IFSB is an international standard-setting organisation which was officially inaugurated on

3rd November 2002 and started operations on 10th March 2003. The organisation promotes

and enhances the soundness and stability of the Islamic financial services industry by issuing

global prudential standards and guiding principles for the industry, broadly defined to include

banking, capital markets and insurance sectors. The standards prepared by the IFSB follow a

lengthy due process as outlined in its Guidelines and Procedures for the Preparation of

Standards/Guidelines, which involves, among others, the issuance of exposure drafts, holding

of workshops and where necessary, public hearings. The IFSB also conducts research and

coordinates initiatives on industry-related issues, as well as organises roundtables, seminars

and conferences for regulators and industry stakeholders. Towards this end, the IFSB works

closely with relevant international, regional and national organisations, research/educational

institutions and market players.

For more information about the IFSB, please visit www.ifsb.org


                                TECHNICAL COMMITTEE

                                        Chairman

            H.E. Dr Abdulrahman A. Al-Hamidy – Saudi Arabian Monetary Agency

                                    Deputy Chairman

      Mr. Osman Hamad Mohamed Khair – Central Bank of Sudan (until 15 August 2009)

                                        Members*

Dr Sami Ibrahim Al-Suwailem               Islamic Development Bank

Mr Khalid Hamad Abdulrahman Hamad         Central Bank of Bahrain

Mr Gamaal M. Abdel-Aziz Negm              Central Bank of Egypt

Dr Mulya Effendi Siregar

                                          Bank Indonesia

(until 31 Mar 2009)

Mr Ramzi A. Zuhdi

                                          Bank Indonesia

(from 1 April 2009)

Mr Hamid Tehranfar

                                          Central Bank of the Islamic Republic of Iran

(until 31 Mar 2009)

Mr Abdolmahdi Arjmand Nehzad

                                          Central Bank of the Islamic Republic of Iran

(from 1 April 2009)

Dr Mohammad Yousef Al-Hashel              Central Bank of Kuwait

Mr Bakarudin Ishak

                                          Bank Negara Malaysia

(until 31 Mar 2009)

Mr Ahmad Hizzad Baharuddin

                                          Bank Negara Malaysia

(from 1 April 2009)

Dr Nik Ramlah Mahmood                     Securities Commission of Malaysia

Mr Pervez Said

                                          State Bank of Pakistan

(until 31 Mar 2009)

Ms Lubna Farooq Malik

                                          State Bank of Pakistan

(from 1 April 2009)

Mr Mu’jib Turki Al Turki                  Qatar Central Bank

Dr Abdulaziz Abdullah Al Zoom             Capital Market Authority of Saudi Arabia

Mr Chia Der Jiun                          Monetary Authority of Singapore

Mr Saeed Abdulla Al-Hamiz

                                          Central Bank of United Arab Emirates

(until 31 Mar 2009)

Mr Khalid Omar Al-Kharji

                                          Central Bank of United Arab Emirates

(from 1 April 2009)

*In alphabetical order of the country the member represents

                                                                                       i


     SOLVENCY REQUIREMENTS FOR TAKĀFUL OPERATIONS WORKING GROUP

                                           Chairman

                      Mr. Chia Der Jiun - Monetary Authority of Singapore

                                      Deputy Chairman

                 Mr. Osman Hamad Mohamed Khair - Central Bank of Sudan

                                           Members*

Mr Muhammad Azam                            The Islamic Corporation for the Insurance of

                                            Investment and Export Credit

Mr Fouad A. Wahid Abdulla                   Central Bank of Bahrain, Bahrain

Ms Zarita Barkhuizen                        Hannover Retakaful, Bahrain

Mr Vasilis Katsipis                         A.M. Best Europe

Dr Manfred Dirrheimer                       FWU Group, Germany

Mr James A. Smith                           Ernst & Young (Hong Kong), Hong Kong

Mr Ir. Isa Rachmatarwata M. Math            Ministry of Finance, Indonesia

Ms Yatty Nurhayati                          Ministry of Finance, Indonesia

Mr Murad Al-Haj Mahmoud                     Insurance Commission of Jordan, Jordan

Mr Alfadino Akbar Ali Akbar                 Bank Negara Malaysia, Malaysia

Mr Mohamed Hassan Md Kamil                  Syarikat Takaful Malaysia Berhad, Malaysia

Mr Adel Saleh Abalkhail                     Saudi Arabian Monetary Agency, Saudi Arabia

Mr Dawood Taylor                            Prudential Ltd, Saudi Arabia

Mr Wan Siew Wai                             Fitch Ratings Singapore Pte. Ltd., Singapore

Mr Nazeem Ebrahim                           Oasis Group Holdings (Pty) Ltd., South Africa

Mr Peter Casey                              Dubai Financial Services Authority, United Arab

                                            Emirates

Mr Parvaiz Siddiq                           Noor Takaful, United Arab Emirates

*In alphabetical order of the country of which the member’s organisation represents

                 ISLAMIC DEVELOPMENT BANK SHARĪ`AH COMMITTEE*

                                           Chairman

                              Sheikh Mohamed Mokhtar Sellami

                                      Deputy Chairman

                    Sheikh Saleh Bin Abdulrahman Bin Abdulaziz Al Husayn

Sheikh Dr Abdulsattar Abu Ghuddah           Member

Sheikh Dr Hussein Hamed Hassan              Member

Sheikh Mohammad Ali Taskhiri                Member

Sheikh Mohamed Hashim Bin Yahaya            Member

                 SECRETARIAT, ISLAMIC FINANCIAL SERVICES BOARD

Professor Rifaat Ahmed Abdel Karim          Secretary-General

Mr Martin Roberts                           Consultant

Professor Simon Archer                      Consultant

Azli Munani                                 Assistant Project Manager

                                                                                            ii


                                               Table of Contents

ACRONYMS ............................................................................................................................. IV

A.   INTRODUCTION ............................................................................................................. 1

       Background................................................................................................................... 1

       General Principle .......................................................................................................... 1

       Main Objectives ............................................................................................................ 2

       Scope of Application..................................................................................................... 2

       Specificities of Solvency Requirements for Takāful (Islamic Insurance) Undertaking . 2

       Valuation of Assets and Liabilities ................................................................................ 5

             Valuation of Technical Provisions....................................................................... 5

B.   KEY FEATURES FOR MINIMUM SOLVENCY REQUIREMENTS................................. 6

DEFINITIONS .......................................................................................................................... 24

APPENDIX............................................................................................................................... 27

                                                                                                                                         iii


 ACRONYMS

BOD      Board of directors

IAIS     International Association of Insurance Supervisors

ICP      Insurance Core Principles of the IAIS

IFSB     Islamic Financial Services Board

JWG      Joint Working Group between the IAIS and the IFSB

MCR      Minimum capital requirement

MTC      Minimum target capital

PIF      Participants’ Investment Fund

PRF      Participants’ Risk Fund

PCR      Prescribed capital requirement

PPR      Prudent Person Rule

PTC      Prescribed target capital

QR       Quantitative Restrictions

TO       Takāful operator

                                                            iv


                                           Bismillahirrahmanirrahim.

              Allahumma salli wasallim ‘ala Sayyidina Muhammad wa’ala ālihi wasahbihi

A.         INTRODUCTION

Background

1.         The Islamic Financial Services Board (IFSB) and the International Association of

           Insurance Supervisors (IAIS) established a Joint Working Group (JWG) which

           produced a paper “Issues in Regulation and Supervision of Takāful (Islamic

           Insurance) published in August 2006. The Issues Paper grouped the issues under the

           following four major themes: a) corporate governance; b) financial and prudential

           regulation; c) transparency, reporting and market conduct; and d) supervisory review

           process, with the conclusion that these issues should be addressed in an integrated

           manner. It also identified corporate governance for Takāful as the priority area, as it

           embraces the industry’s fundamental issues such as acceptable Takāful models and

           their essential parameters, the relationship between Takāful participants’ and

           shareholders’ funds, and Sharī’ah governance, among others. In November 2009, the

           IFSB issued the Guiding Principles on Governance for Takāful (Islamic Insurance)

           Undertakings. This Standard is a successor to, and builds on, that work, in line with

           the priorities set out by the JWG.

General Principle

2.         In view of the on-going development for an international solvency requirement for

           insurance undertakings, the Standard does not prescribe specified quantitative

           techniques. Rather, the Standard sets out important key principles for the structure of

           solvency requirements for a Takāful undertaking. The IFSB has taken account of the

           IAIS’s initiatives on solvency standards and assessment, to benefit from and build on

           the established international frameworks set out by the IAIS. This approach is

           adopted in order to ensure that the supervision of Takāful is established on sound

           regulatory principles which are consistent with, and no less robust than, those

           established in conventional insurance. Hence the Standard contained herein is

                                                                                           1

           primarily based on the IAIS regulatory capital requirements , with the necessary

           modifications and adaptations to cater for the specificities and characteristics of a

           Takāful undertaking.

3.         This Standard should be read together with the Guiding Principles on Governance for

                                                                 2

           Takāful (Islamic Insurance) Undertakings that outlined, inter alia, key principles on

           governance structures, key terminologies, concepts and operations of a Takāful

           undertaking. This will facilitate further understanding of this Standard and its

           recommended solutions.

1

  The IAIS has issued three standards and associated guidance papers and standards on solvency assessment in

October 2007 and October 2008. The papers identify key features which the IAIS encourages supervisors to consider

in their particular solvency regimes to assist them in establishing and maintaining well-regulated insurance industries.

They encompass quantitative and qualitative aspects of solvency assessment and provide guidance to supervisors in

the areas of (a) the structure of regulatory capital requirements; (b) enterprise risk management for capital adequacy

and solvency purposes; and (c) the use of internal models for risk and capital management by insurers. Further

standards and guidance papers are under development.

2

  IFSB-8, November 2009.

                                                                                                                      1


Main Objectives

4.         The overall objective of this document is to set forth key principles on the solvency

           requirements for Takāful undertakings. This document is built around the following

           premises and objectives:

           i.        To increase the likelihood that a Takāful undertaking would be able to meet

                     all its contractual obligations and commitments;

           ii.       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;

           iii.      To provide a buffer so that even if the Takāful participants are to suffer a loss

                     in the event of failure of a Takāful undertaking, the impact can be limited or

                     reduced especially the systemic effects; and

           iv.       To foster confidence amongst the general public, in particular Takāful

                     participants, in the financial stability of the Takāful sector.

Scope of Application

5.         This Standard is applicable to all Takāful and Retakāful3 undertakings. However,

           supervisory authorities may, at their discretion, extend the applicability to Takāful

           “window” operations that fall within their jurisdictions.4

6.         This Standard is focused on the Takāful undertaking as a single entity and the issues

           of group-wide supervision are not covered in this Standard. The IAIS is actively

           developing standards and guidance in this area. The IFSB will monitor these

           developments and may make further proposals in the future.

7.         This Standard places particular emphasis on the solvency requirements for Takāful

           Participants’ Risk Fund (PRF) which are the underwriting funds – i.e. an element of

           the business that is inherent in the underwriting activities,, and the contributions to

           which are made on the basis of a Tabarru’ commitment. When considering the

           solvency requirements for those forms of Family Takāful business which have a

           savings element in a segregated fund, called the Participants’ Investment Fund (PIF),

           normally this latter fund is not taken into account in assessing whether the solvency

           requirements of a Takāful undertaking are met as there is typically no recourse to

           certain surplus amounts in individual PIFs in order to meet a deficiency in a PRF. In

           addition, a PIF is typically a pure investment fund, and the related investment risks

           are fully borne by the Takāful participants with no need for capital backing from the

           TO5 in the form of a Qarḍ facility.6 (If in fact an operation is constituted such that

           investment profit in PIFs is available to meet deficiencies in a PRF or such that

           investment risks of PIFs are not fully borne by the participants, a different treatment

           would be necessary.)

Specificities of Solvency Requirements for Takāful (Islamic Insurance) Undertaking

8.         Insurance or Takāful undertaking is an inherently risky business, because the fund,

           whether conventional or Takāful, is exposed to contingencies whose outcome cannot

           be known at the beginning of the contract. For example, it cannot be known whether

           a particular driver will crash his car, or whether a particular house will catch fire.

           Where a large number of individual risks are involved, the probabilities become more

           predictable, which is one rationale for a principle of mutual guarantee. However,

3

  In the Standard, any reference to “Takāful” is to be taken to include Retakāful.

4

  We note that, while the application of this Standard to Retakāful is relatively straightforward, its application to a

Takāful “window” will need to recognise that the TO’s funds are directly exposed to substantial insurance risk from

the non-Takāful participants. There may also be a question whether some of the TO’s assets, being non-Sharī’ah

compliant, can be available for a potential Qarḍ to the PRF.

5

   For convenience, any reference to “TO” in the rest of this document shall mean “Islamic insurance / Takāful

operator”. Reference to “Takāful” shall equally mean Islamic insurance.

6

  Operational risk in relation to managing the assets of a PIF is, however, relevant to the capital requirements of a

TO.

                                                                                                                      2


           adverse deviations may still occur. For example, a storm may cause damage to a

           large number of houses in a particular area. In addition, because premiums or

           contributions are invested until the funds are needed to pay claims (which can be an

           extended period, particularly for classes of insurance related to liability), there are

           risks on the asset side of the balance sheet. The principal concern of insurance

           supervisory authorities is that the undertaking should be able to meet its liabilities,

           especially policyholder claims, as they fall due, and that this should remain true even

           in adverse circumstances (such as a major storm). Current international thinking7 is

           that in modern insurance regimes, it should be made explicit that the undertaking

           should have a given probability of meeting all its liabilities over a defined period (such

           as 99.5% over 1 year).

9.         Similar to conventional insurance, the goal of a supervisory authority in assessing a

           Takāful undertaking’s solvency position is to ensure that the solvency levels of all

           PRFs are consistent with their overall risk profiles and to enable early intervention if

           the solvency buffer does not sufficiently cover the risks. However, in a Takāful

           undertaking, a TO is supposed to be the mudarib and/or wakil (depending on which

           model is adopted) that administers the PRF, and in return will be remunerated via

           profit share (in the Muḍārabah model) or fees (in the Wakālah model) in the PRF.

10.        A typical Takāful undertaking thus consists of a two-tier structure that is a hybrid of a

           mutual, and a proprietorship company – which is the TO. In a Takāful arrangement,

           the Takāful participants contribute a sum of money as Tabarru’ commitment into a

           common fund, which will be used mutually to assist the members against a defined

           compensation or loss. The distinctive rights and obligations between the TO and

           Takāful participants require a clear segregation of the PRF from the TO’s

           shareholders' funds. The main reason for this is that, in the absence of misconduct or

           negligence, a TO is not contractually accountable for any deficit or loss arising from a

           PRF. However, for regulatory solvency purposes a TO may be required to hold

           adequate capital in order to provide a Qarḍ facility to meet any deficiency in the PRF

           (resulting from a deficit that exceeds the amount of any accumulated reserves in a

                   8

           PRF) or to remedy any situation in which Takāful cannot meet legitimate claims as

           they fall due because of liquidity shortage. Such a Qarḍ facility will typically be

           essential to enable a Takāful undertaking to meet regulatory solvency requirements,

           as there will not be sufficient reserves within PRFs for this purpose.

11.        However, the extent to which a Qarḍ facility enables a Takāful undertaking to meet

           regulatory solvency requirements depends, inter alia, on the terms on which such

           Qarḍ facilities are made available by TOs in the light of the regulations in a particular

           jurisdiction, including, in particular, those that determine the status of an outstanding

           amount of a Qarḍ facility (that has already been drawn down as a Qarḍ) in the case

           where a PRF enters into an insolvent winding-up. In such a case, there are two

           possible scenarios (see also paragraph 41 below):

           i.         Any outstanding Qarḍ would rank pari passu with participants’ claims, so that

                      the deficiency would be shared pro rata;

           ii.        Participants’ claims would rank above any outstanding Qarḍ.

           Only in the second case should the Qarḍ facility be considered to be fully part of

           regulatory capital. In the first case, it might be considered as making some

           contribution to regulatory capital.

12.        The analysis in paragraph 10 above of differing pools of assets within the same legal

           entity is additionally based on the assumption that the boundaries between them will

7

  The IAIS Common Structure Paper for Assessment of Insurer Solvency adopted in 2007 says that "Capital

requirements should be calibrated such that, in adversity, assets will exceed technical provisions with a specified

level of safety over a defined time horizon".

8

  The term 'deficit' refers to the case where claims and other expenses exceed contributions for a financial period,

while 'deficiency' refers to the situation where a deficit exceeds any reserves in the fund, so that the fund has a debit

balance.

                                                                                                                       3


    be respected both when the entity is a going concern and in any form of insolvency

    proceeding. If this assumption is not warranted, supervisory authorities should

    address these issues with the relevant authorities in their own jurisdictions. This

    Standard does not deal further with the complex issue of insolvency law.

13. An essential part of good governance by a TO is the existence of an appropriate

    mechanism for sustaining a Takāful undertaking’s solvency and adherence to sound

    risk management. In view of their paramount importance, particularly their effects on

    systemic stability, TOs should always bear these in mind while planning and mapping

    their governance strategies. This is necessary whatever the strength of the solvency

    regime imposed by the supervisory authority. Although, as a matter of principle,

    Takāful participants are expected to bear the risk of insolvency of a PRF whenever

    the contributions they make (together with income from PRF assets and any reserves

    in the PRF) cannot meet the total amount of claims, it has been well accepted as part

    of the prudential framework that TOs shall put in place appropriate mechanisms to

    buffer any deficiencies suffered by PRFs. (See, however, paragraph 10 above.)

14. Some TOs may use different operational models or product terms as part of their

    market differentiation or a commercial expression. While it is not the intention of the

    IFSB to require TOs to change the way they manage the business and risks, TOs are

    required to use the substance of the Sharī’ah rules and principles governing the

    contracts to form the basis for an appropriate treatment in deriving their minimum

    solvency requirements.

15. Apart from that, the solvency requirements for Takāful undertakings should take

    account of the Sharī’ah-compliant assets in which the undertakings will invest.

    Depending on the nature of the solvency regime, risk weightings or quantitative

    restrictions (QR) may need to be applied to these assets. In some instances, for

    example cash or equities, the treatment will parallel that for conventional insurers. For

    other Sharī’ah-compliant instruments, the IFSB’s Capital Adequacy Standard for

    Institutions (other than Insurance Institutions) Offering Only Islamic Financial Services

    (December 2005) provides a helpful analytical background in addressing these

    questions.

                                                                                            4


Valuation of Assets and Liabilities

16.         The IFSB recognises that it is essential to assess the overall financial position of a

            Takāful undertaking based on consistent measurement of assets and liabilities

            particularly the identification and measurement of risks and their potential impact on

            all components of the balance sheet. To a significant extent the detailed requirements

            in relation to a solvency buffer depend on the valuation of assets and liabilities in the

            solvency regime. The development of this Standard, and of the IAIS's work on

            solvency requirements and assessment, has taken place in parallel with that of

            international financial reporting for insurance. The intention is that all of these should

            be based on a market consistent approach to the valuation of both assets and

            liabilities.

17.         However, until further progress is made on internationally agreed accounting

            standards for insurance it is inevitable that solvency requirements in different

            jurisdictions will be heavily influenced by the accounting and actuarial framework that

            applies in each jurisdiction (in terms of the valuation basis and assumptions that may

            be used and their impact on the values of assets and liabilities that underpin the

            determination of regulatory solvency requirements). In this regard, this Standard is

            not intended to deal with such issues as restrictions on categories of assets that

            "count" for solvency purposes, the determination of any risk margin within technical

            provisions, and the methods to be used for calibrating of solvency requirements.

            Rather, the Standard outlines the key features of solvency requirements for Takāful

            undertakings and sets out a number of principles to be followed by supervisory

            authorities in structuring such requirements within their jurisdiction.

18.         In considering asset values for the purposes of assessing the financial position of a

            Takāful undertaking, supervisory authorities should take account of the suitability of

            those assets for the purposes of backing the undertaking's liabilities and absorbing

            the risks to which it is exposed. This Standard is not intended to determine whether,

            in addition, there should be any QR on assets which "count" for solvency purposes;

            or to specify any restriction or risk weighting "haircut" that should be applied.

            However, where such QR are not applied, TOs, and supervisory authorities should

            follow a "prudent person"9 approach.

            Valuation of Technical Provisions

19.         The valuation of technical provisions in the PRF should be undertaken on a market-

            consistent basis that is consistent with the assessment by market participants of

            value and risk or the principles, methodologies and parameters that market

            participants expect to be used. Technical provisions shall comprise two components

            – the current central best estimate of the Takāful underwriting obligations (discounted

            to the net present value) and a risk margin. The risk reflected in the risk margin in

            technical provisions relates to all liability cash flows and thus to the full time horizon of

            the Takāful contracts underlying these technical provisions. It should generally not be

            less than that necessary to bring the technical provisions to an amount, in return for

            payment of which a willing third party, acting on an arms length basis, would be

            prepared to accept those liabilities through a (hypothetical) portfolio transfer. Each

            component of the technical provisions shall generally be explicitly determined in order

            to support the objectives of transparency and comparability and also to facilitate

            convergence.

9

  There are essentially two types of regulations which are applied across the world. They are QR, which impose

explicit limits on holdings in risky asset classes, and the Prudent Person Rule (PPR), which requires firms to invest

prudently and follow broad principles of portfolio diversification and asset-liability matching. Where undertakings

exceed QR then the value of assets held in excess of these restrictions are not taken into account for solvency

purposes. Where QR do not apply and the PPR approach is followed, then the supervisor should take account of the

extent to which assets (a) are not adequately diversified; (b) are inappropriately illiquid; (c) are not readily

marketable; or (d) do not reasonably match liabilities in duration and currency, in determining the undertaking's

solvency requirements

                                                                                                                   5


B.         KEY FEATURES FOR MINIMUM SOLVENCY REQUIREMENTS

20.        As mentioned in paragraph 2, the Standard is intended to complement the existing

           work of the IAIS on putting in place a sound solvency regime for insurance. While

           generally Takāful undertakings share some similarities with conventional insurers in

           attempting to serve certain economic objectives, it should be noted that structurally

           Takāful undertakings can be distinguished from conventional insurers. These

           differences are the key conceptual factors for developing the solvency requirements

           for a Takāful undertaking.10

Key Feature 1: The solvency requirements for Takāful undertakings must adopt a total

                                   11

balance sheet approach to ensure that risks are appropriately recognised and

consistently valued and to identify the interdependence between assets, liabilities,

regulatory solvency requirements for PRF and the shareholders’ funds of the TO.

However, the total balance sheet approach must address the clear separation of PRF

and the shareholders’ funds of the TO.

21.        Given that one of the key specificities of a Takāful undertaking is a distinct separation

           between the Takāful and TO’s shareholders’ funds, the solvency requirements for

           Takāful undertakings should be set separately as illustrated in Figure 1. The first level

           of solvency requirements is to ensure adequate solvency resources in the PRF to

           provide assurance (on a defined probabilistic basis, and taking account of the

           possibility of adverse developments in all the areas of risk to which the fund is

           exposed) that the PRF can meet claims from Takāful participants. The second level

           of solvency requirements is to ensure adequate capital resources of the TO to meet

           its own financial and legal obligations, including the possible need to provide capital

           backing in a way of a Qarḍ facility to the PRF.

           Figure 1: General approach to the solvency and capital requirements for a Takāful

                         12

           Undertaking

           Panel A: Takāful Undertaking where the PRF is self-sufficient

                             Shareholders' Fund                                     PRF

                                                                                              Excess

                                                                                               PCR

                                                                                               MCR

                                                Excess                                     Risk Margin

                                                 PTC

                                                                       Assets

                                                 MTC

                                                                                              Central        Technical

                        Assets                                                              Estimate of      Provision

                                                                                              Takaful

                                                                                           Underwriting

                                               Liabilities                                   Liabilities

10

   Refer to Paragraph 18 in the Guiding Principles on Governance for Islamic Insurance (Takāful) Operations.

11

   The term ‘total balance sheet approach’ needs to be understood subject to the distinction between the

shareholders’ funds and the funds of Takāful participants (PRFs and investment accounts). Of the shareholders’

funds, only the amount of the Qarḍ facility may be counted as capital in assessing the solvency of a PRF.

12

   Refer to paragraph 34 for further explanation of the abbreviations used.

                                                                                                                    6


          Panel B: Takāful Undertaking where the PRF relies on a Qarḍ Facility to meet

          Solvency Requirements

                                     Shareholders' Fund                                PRF

                                                                                             Excess

                                                                   "Notional Assets"

                                                                    right to call Qard

                                                                                              PCR

                                                                                              MCR

                     Assets "earmarked" to

                       back Qard facility               Excess                             Risk Margin

                                                     Qard Facility

                                                          PTC

                                                                                                         Technical

                                                                                                         Provision

                                                         MTC

                                                                                             Central

                                                                                           Estimate of

                          Assets                                                             Takaful

                                                                                           Underwriting

                                                                                            Liabilities

                                                       Liabilities

          Where a Qarḍ facility is required to enable a PRF to meet its solvency requirement, it

          should generally be set up at a value which will provide some buffer over and above

          the minimum solvency requirement. This is to allow the PRF to meet its requirements

          on a continuous basis notwithstanding reasonably foreseeable fluctuations in asset

          and liability valuations. The assets backing a Qarḍ facility should be `earmarked’ for

          this purpose. That is, they should be specifically identified and held in a discrete

          account separately from other assets in the shareholders’ fund. In assessing the

          adequacy of a Qarḍ facility for solvency purposes, the supervisory authority should

          look through to the earmarked assets in the same way as provided in paragraph 18.

22.       To determine the basic structure of solvency requirements for PRFs and the TO’s

          funds respectively, the obligations of the whole undertaking need to be identified.

          Here are the main obligations (financial and legal) of the Takāful undertaking in the

          context of solvency requirements:

          A.        PRFs

          i.        The objective of solvency requirements at PRF level is to provide a high

                    degree of confidence that the PRF can withstand adverse conditions over the

                    expected term of its assets and liabilities. Therefore, the PRF should hold

                    assets equal to the technical provisions of that PRF (valued in the manner

                    described in paragraph 16) plus additional solvency resources (sometimes

                    referred to as solvency margin reserves). The additional solvency resources

                    are the amount of additional assets a PRF must hold to cover (1) possible

                    underestimation of the technical provisions and (2) the risk of measurement

                    error inherent in determining the economic values of assets, namely that their

                                                                                                   13

                    realisable values may be less than their carrying amounts . Subject to

                    paragraph 10 above, the additional solvency resources may include a

                    standby back-up facility provided by the TO on a Qarḍ basis (see B.ii below).

                    Where such a facility does not fully meet the requirements for inclusion in

                    regulatory capital, but the regulator nonetheless allows some credit to be

                    taken for it for solvency purposes (see paragraph 11.ii), the amount of the

                    solvency margin reserve in the relevant PRF will need to be correspondingly

                    greater.

13

   The IAIS Draft Guidance Paper on the Structure of Capital Resources for Solvency Purposes (January 2009)

suggests that for solvency purposes adjustments to the carrying values of assets may be made either by making a

                                                                                                              7


          ii.        The additional solvency resources will be calculated for all risks that could

                     have a negative financial impact on a PRF. They will be calculated to cover

                     risks over the expected term of the assets and liabilities. The framework

                     should identify the main categories of risks such as credit, market,

                     underwriting, liquidity and operational. With regard to the treatment of assets,

                     their carrying values would normally be fair values in accordance with

                     international financial reporting standards, but the solvency margin reserve

                     would include an amount to cover the risk of the realisable value being less

                     than the carrying amounts (if the carrying value is not in fact fair value,

                     appropriate adjustments may be required to the solvency margin reserves).

                     In the case of conventional insurance contracts involving significant

                     acquisition costs, for solvency purposes exit or similar values would be used

                     (rather than deferring and amortising acquisition costs), but the intangible

                     nature of such assets would require the inclusion of an appropriate amount in

                     the solvency margin reserve.

          B.         Shareholders’ Funds

          i.         The TO needs to have sufficient capital resources to be able to withstand

                     unexpected increases in management expenses or reductions in income

                     which could cause operating losses to the TO leading to financial distress if it

                     were undercapitalised.

          ii.        In addition, subject to the applicable regulations, the TO's capital resources

                     may need to be sufficient to allow it to provide additional capital (as a Qarḍ

                     facility available to be drawn down) to the PRF should this be necessary to

                     cover a shortfall in that fund’s capital resources or a short-term liquidity need.

          iii.       The assessment of the amount of the capital resource requirements for the

                     TO should be generally based on the potential volatility of expenses, and

                     most importantly, the level, volatility and flexibility of the TO’s income, after

                     taking account of the amount needed for the Qarḍ facility (that is, on the

                     potential call on the TO to provide additional capital in the form of Qarḍ if

                     required).

23.       The TO is expected, through licensing and regulatory requirements, to offer a Qarḍ

          facility out of its shareholders’ funds where this is necessary to meet the required

          solvency level of the PRFs, with repayment of any Qarḍ drawn down to be made from

          future participants’ surpluses arising from the PRFs. The right to receive repayment in

          respect of a Qarḍ already provided should not be counted as an asset for the purpose

          of assessing the TO's ability to meet its own solvency resource requirements as set

          out in paragraph 22.B above. Similarly, any assets representing a standby facility

          (see A.i above) that has been accepted by the regulator as regulatory capital for the

          purposes of a PRF cannot also be counted as assets supporting the solvency of the

          shareholders’ fund (see paragraphs 26 and 27 below)

deduction from their values or by making a capital charge of the same amount (or by a combination of both methods).

The wording adopted here assumes that the capital charge approach is used.

                                                                                                                 8


Key Feature 2: The solvency requirements should be established at a level such that

the respective amounts of solvency resources in the Takāful and shareholders’ funds

are adequate to meet their respective financial obligations as they fall due, bearing in

mind that part of the shareholders’ funds may be ‘earmarked’ to cover a Qarḍ facility.

24.         In assessing the solvency requirements of a Takāful undertaking, it is essential to

            ensure that there are adequate and appropriate solvency resources in the PRFs and

            shareholders’ funds to support the respective financial obligations of each of the

            funds as they fall due, with the TO’s capital resources being sufficient to cover its

            own business risks. In this connection, without prejudice to the operation of any Qarḍ

            facility, it is crucial that there be a clear separation between Takāful and

            shareholders’ funds so that there is no possibility of contagion between them.

25.         In addition to ensuring that the solvency requirements of all funds under its control

            are met, a TO should manage these funds in a sound and prudent manner, In

            particular, the TO should endeavour, over time to bring the reserves in a PRF to a

            level at which the fund becomes self-sustaining with sufficient resources to meet

            solvency requirements without the need to rely on a Qarḍ.

            Earmarked amount

26.         Where a TO provides capital backing in the way of a Qarḍ facility, the undrawn Qarḍ

            facility should be considered as being ‘earmarked’ within the shareholders’ funds to

            meet the solvency requirements of the PRF. (See Figure 1 panel B above.) This

            amount should be distinct from the amount of the TO’s capital required to meet its

            own solvency requirements. Capital available for solvency purposes for the PRF

            would therefore consist of (i) reserves in PRFs (retained underwriting surplus or

            investment profit) i.e. Takāful participants’ equity, plus any amount of drawn-down

            Qarḍ, and (ii) undrawn Qarḍ facility (an earmarked amount within the shareholders’

                     14

            equity) . Any amount drawn down from the Shareholders' Fund as Qarḍ facility is

            part of the assets of the recipient PRF. Correspondingly, this drawn down amount

            will be part of the Shareholders' equity and is represented by a Qarḍ repayable by the

            PRF. As noted in paragraph 24 above, it is expected that the Takāful participants’

            equity would gradually become sufficient to meet the solvency requirements, thus

            making the Qarḍ facility superfluous.

27.         Where there are ring-fenced PRFs, any such earmarked Qarḍ amount held in respect

            of an individual PRF must not be double counted for solvency calculation purposes.

28.         To ensure the adequacy of a Qarḍ facility, a TO should carry out regular actuarial

            appraisals of the solvency of the relevant PRF, so as to determine the amount of any

            shortfall with respect to the solvency requirement which would need to be covered by

            the Qarḍ facility. Moreover, the assets represented by a Qarḍ facility should be kept

            in a suitable form to serve for draw-down of the Qarḍ facility into the PRF.

14

   This is dependent on the Qarḍ facility meeting the conditions to count as capital as discussed in paragraphs 11 and

41.

                                                                                                                     9


            Transferability between the PRFs

29.         The solvency requirements for a Takāful undertaking should reflect and take account

            of any limitations on the transferability of funds within the undertaking. Such

            limitations may arise from the contractual terms or the legal framework that governs

            the undertaking's operations. Some Takāful products may be written in so-called ring-

                            15

            fenced funds , where part of the business is clearly segregated from the rest. In

            such cases the assets or retained underwriting surplus of the fund may be strictly

            isolated from the other lines of business so that they can only be used to meet the

            Takāful and Retakāful obligations with respect to which the ring-fenced fund has been

            established.

30.         For this reason, when assessing the solvency of the PRFs, the amount of solvency

            resources eligible to cover the solvency level must be adjusted to take account of the

            “non-transferability” of solvency resources between ring-fenced funds. Depending on

            the nature of the restrictions on transferability, it will generally be appropriate for each

            ring-fenced fund to be subject to its own specific solvency requirements. In such

            circumstances, the technical provisions should be calculated and reported separately

            for each PRF and these technical provisions together with appropriate solvency

            requirements should be covered by assets of appropriate value and quality in

            accordance with the applicable QR or PPR.

31.         It is important that the supervisory authority be fully aware of any restrictions on the

            transferability of assets between lines of business. Takāful participants should also be

            informed of this, so that they understand the risks (if any) to which they may,

            indirectly, be exposed through lines of business other than those in which they

            directly participate, and understand too any limitations on the extent to which losses

            arising in "their" business may be absorbed by surplus funds in another. Accordingly

            the regulatory or supervisory regime should ensure that, wherever possible, there is a

            clear contractual term or legal framework. Should this be absent, the default

            assumption must be that there is no transferability, and this will generally imply a

            higher total capital requirement in the undertaking.

32.         To the extent that either integrated or separate Takāful PRFs or line-of-business

            classes are supported by the shareholders’ funds through a Qarḍ facility, the amount

            of shareholders’ funds that has been earmarked for the Qarḍ facility (but not any

            other part of shareholders’ funds) should in principle count fully for the purpose of

            determining the solvency of the PRFs. But such shareholders’ funds should not be

            capable of being "double counted" (for example, in determining the solvency of the

            TO itself as a business undertaking). In practice, this might be best achieved by

            requiring that:

            i.       Individual PRFs, non-transferable between lines of business, should each

                     meet the solvency requirement;

            ii.      Where the assets of a group of PRFs are fully transferable between those

                     funds, the solvency requirements should be applied to the totality of those

                     funds;

            iii.     In both cases, for the purpose of complying with the solvency requirement,

                     PRFs should be able fully to count earmarked funds available from a Qarḍ

                                                                                                        16

                     facility as well as those actually drawn down under a Qarḍ facility .

15

   This is sometimes done in conventional insurance for with-profits or investment linked policies.

16

   This is dependent on the Qarḍ facility meeting the conditions to count as capital as discussed in paragraph 11.

                                                                                                                   10


Key Feature 3: The solvency requirements should establish solvency control levels at

the respective Takāful and shareholders’ funds, that trigger proper interventions by TO

and the supervisory authority when the available solvency is less than the solvency

control level.

33.        The solvency requirements for Takāful undertakings should emphasise the

           importance of setting up the solvency control at two levels, in both shareholders’ fund

           and the PRF. By setting up the solvency control at two levels, a set of prompt actions

           could be taken by the TO and the supervisory authority to avert possible loss to

           participants arising from an insolvency position. These control levels should be set

           such that intervention actions may be taken at a suitably early stage in a Takāful

           undertaking’s difficulties. In this context, any adverse condition could be addressed in

           a realistic timeframe, and the appropriateness of the control levels should be

           examined in relation to the nature of the intervention actions..

34.        The solvency requirements should be based on the following four concepts: minimum

           capital requirement (MCR) and prescribed capital requirement (PCR) for the PRFs,

           and minimum target capital (MTC) and prescribed target capital (PTC) for the

           shareholders’ funds. Any amounts earmarked as a Qarḍ facility are part of the

           shareholders’ funds but would for solvency purposes be treated as part of the PRFs

           for which they were earmarked. 17

35.        The PCR/PTC signifies the highest solvency level that enables the funds to absorb

           significant unexpected losses while MCR/MTC signifies a solvency level of which a

           breach will invoke the strongest regulatory actions. Any breach of

           MCR/PCR/MTC/PTC at the level of either the PRF or shareholders’ funds should

           trigger immediate attention from the TO and the supervisory authority. In any case

           where a TO is unable to restore the required solvency control level applicable to any

           PRF, or its own shareholders’ funds, or the whole undertaking, the TO should put

           forward a plan acceptable to the supervisory authority to meet the solvency

           requirement within a short period. Where no acceptable plan is put forward and

           implemented within a reasonable time specified by the supervisory authorities or laid

           down in law, the undertaking should be prohibited from continuing to write further

           business.

                                                                                                        18

36.        Possible intervention actions that could be taken by a supervisory authority include :

           i.        measures to address solvency levels such as the draw-down of the Qarḍ

                     facility from the shareholders’ fund to the PRF, requesting capital and

                     business plans for restoration of solvency resources to required levels,

                     limitations on redemption or repurchase of equity or other instruments and/or

                     dividend payments etc;

           ii.       measures intended to protect Takāful participants pending the restoration of

                     the solvency levels, such as restrictions on undertaking new business,

                     investments, Retakāful/reinsurance arrangements etc;

           iii.      measures that are intended to enable the supervisory authority to better

                     assess and/or control the situation, either formally or informally, such as

                     increased supervision activity or reporting, or requiring external auditors or

                     actuaries to undertake an independent review or extend the scope of their

                     examinations; and

           iv.       measures that strengthen or replace the TO’s management and/or risk

                     management framework and overall governance processes in the Takāful

                     undertaking.

           Illustrations of types of intervention actions are provided in the Appendix.

17

   Refer to paragraph 26.

18

   These are based on the actions described in the IAIS Guidance paper on the structure of regulatory capital

requirements, dated October 2008.

                                                                                                         11


37.        With regard to the draw-down of a Qarḍ facility to a PRF, the regulatory framework

           should either define, or allow discretion to supervisory authorities to determine, the

                           19

           control level applicable to the PRF. The supervisory authorities would then be able

           to request the TO to draw down the Qarḍ facility to the PRF immediately once the

           control level is breached in order to expedite the restoration of the required solvency

           control level.

19

   While it will be for the relevant authorities in individual jurisdictions to specify the control level, breach of which

would trigger an immediate requirement to draw down Qarḍ, this should never below the level of the technical

provisions (ie the best estimate of the insurance liabilities plus the required margin), and should normally not be less

than the level of the minimum capital requirement.

                                                                                                                       12


Key Feature 4: The solvency requirements should establish criteria for assessing the

quality and suitability of solvency resources in the Takāful and shareholders’ funds to

absorb losses in different financial stages of the respective funds.

38.        The solvency requirements for Takāful undertakings should take into account the

           quality of solvency resources to absorb losses in different financial stages of a

           Takāful undertaking, namely as a going concern, in run-off, winding up and

           insolvency.20 This is because the extent of its loss absorption depends on the type of

           capital, e.g. equity or other capital such as the Qarḍ facility. A holistic approach needs

           to be taken in order to evaluate the extent of loss absorbency overall, and should

           establish criteria that should be applied to evaluate capital elements in this regard.

39.        Given that there is a clear separation between the shareholders and the PRFs in

           Takāful undertakings, the quality of solvency resources should be assessed

           separately to meet the respective solvency requirement. For the shareholders’ funds,

           the assessment of the quality of solvency resources is relatively straightforward as

           the solvency resources should be fully available to meet any financial distress

           affecting the shareholders’ funds. However, in assessing the ability of solvency

           resources to absorb losses in the PRFs, the following characteristics are usually

                                                                                                    21

           considered (see paragraph 11 above and paragraphs 41-43 below ):

           i.         Availability - the extent to which the capital element is fully paid and can be

                      called up on demand to absorb losses as well as upon winding up;

           ii.        Permanency - the extent to which the available capital element cannot be

                      withdrawn; and

           iii.       Absence of encumbrances and mandatory servicing costs - the extent to

                      which the capital element is free from mandatory payments or

                      encumbrances.

40.        The supervisory authority may apply potential limits for the solvency resources to be

           qualified to cover different levels of the solvency requirements of the shareholders’

           and PRFs. In determining the amount of a Takāful undertaking’s solvency resources

           to meet different solvency levels, the supervisory authority may choose a variety of

           approaches: 22

          i.          approaches which categorise solvency resources into different quality classes

                      (“tiers”) and apply certain limits/restrictions with respect to these tiers, (within

                      which individual tiers may be further subdivided) (tiering approaches);

           ii.        approaches which rank capital elements on the basis of the identified quality

                      characteristics (continuum approaches);

           iii.       approaches which do not attempt to categorise or rank capital elements, but

                      apply individual restrictions or charges where necessary.

           To accommodate the quality of capital elements, combinations of the above

           approaches have been widely used. It is likely that, in relation to Takāful, an

           approach with a high degree of granularity – whether within a tiered approach within

           which individual tiers are further divided, or through a less formulaic continuum

           approach – will be appropriate.

           Treatment of the Qarḍ facility for solvency requirements

41.        In order for a Qarḍ facility or Qarḍ to be accepted for solvency purposes, supervisory

           authorities should satisfy themselves that the following conditions are met:

           (i)        the Qarḍ facility provided to a PRF cannot be withdrawn by the TO before the

                      PRF is considered to meet solvency requirements independently of any Qarḍ

                      facility;

20

   The determination of suitable capital within a solvency regime is critically dependent upon the legal environment of

the relevant jurisdiction particularly in recognising a clear separation of Takāful and shareholders’ funds.

21

   Adopted from the IAIS Draft Guidance Paper on the structure of capital resources for solvency purposes.

22

   Adopted from the IAIS Draft Guidance Paper on the structure of capital resources for solvency purposes.

                                                                                                                   13


          (ii)      the TO has given its consent to the supervisory authority that, in a winding-up

                    situation, it will treat any part of the Qarḍ facility that has been drawn down as

                    a Qarḍ as being donated to the PRF to the extent that is necessary in order

                    for participants’ claims to be met in accordance with regulatory obligations (or

                    some other arrangement to the same effect).

42.       The treatment of the Qarḍ facility is a fundamental issue. Any draw-down of a Qarḍ

          facility into a PRF should in principle be repaid from future surpluses of the PRF. A

          particular issue arises in relation to a run-off process, particularly regarding the status

          of claims from Takāful participants on the PRF. It is likely that prior to the run-off of a

          particular PRF, the draw-down of the Qarḍ facility will have been initiated with the

          intent of enabling the PRF to meet its regulatory obligations. Indeed, the supervisory

          authority should not allow a PRF to be run off without a sufficient draw-down of a

          Qarḍ facility to provide reasonable assurance that adequate resources will be

          available within the PRF to meet any obligations arising in the process of run-off. In

          this connection, a voluntary winding-up (as an alternative to run-off) would require the

          supervisor’s authorisation, in which case the supervisor might require that a draw-

          down of a Qarḍ facility had been made prior to the initiation of the voluntary winding-

          up.

43.       The legal and regulatory framework should provide for the determination of the point

          at which it is no longer permissible for a Takāful undertaking to continue its

                     23

          business . The procedures for dealing with insolvent winding-up of a Takāful

          undertaking should be clearly set forth in the law. Due consideration must be given by

          the supervisory authorities to analysing the quality of capital that the Qarḍ facility

          represents when it is drawn down into the PRF particularly in the context of the

          payment priority of a drawn-down Qarḍ in a wind-up situation. The payment priority of

          a drawn-down Qarḍ in a winding-up situation should be clearly stated in the law

          regarding insolvency and winding up and should be disclosed by the TO to the

          policyholders.

23

   The IAIS Insurance Core Principle (ICP) 16 on “Winding-up and exit from the market”.

                                                                                                    14


Key Feature 5: The solvency requirements for Takāful undertakings must have

separate risk adjusted computation and assessment. The risk management framework

must be comprehensive and cover all risks to which the PRFs and the shareholders’

funds are exposed.

44.       Takāful undertakings are in a similar position to conventional insurance undertakings

          with regard to the management of risk. They face similar risk exposures in the

          management of underwriting funds. In this respect, the solvency regime for a Takāful

          undertaking must place emphasis on the undertaking's risk management framework

          and on ensuring that it is appropriate to the complexity, size and mix of the Takāful

          undertaking’s operations. At the same time, the risk management framework has to

          be supported by thorough monitoring and internal control systems.

45.       In the management of risks, a TO faces challenges in adequately defining, identifying,

          measuring, selecting, pricing and mitigating risks across business lines and asset

          classes in the PRFs as well as its own risk exposures with respect to the

          shareholders’ funds. The management of these risk exposures is a continuous

          process that should be carried out in the implementation of the strategy of the

          undertaking and which should allow an appropriate understanding of not only the

          nature and significance of the risks to which the undertaking is exposed but also the

          Sharī’ah rules and principles to which the TO and the Takāful participants are

          contractually bound. Thus, TOs must adopt a sound risk management framework for

          PRFs and the shareholders’ fund.

46.       In this respect, TOs might be seen as managing two distinct sets of risks. The first set

          relates to the TO’s fiduciary responsibility to manage the PRFs under its management

          so as to protect the interests of the Takāful participants. This set of risk components

          is related to the management of PRFs so that they can meet their financial obligations

          as they fall due. The second set of risks relates to the TO itself in the process of

          meeting its financial obligations. It is important that a TO should have adequate

          capital to back the risks arising from its business operations in addition to any capital

          backing provided in the form of a Qarḍ facility to meet possible deficiencies of the

          PRFs. These two sets of risks are the crucial risk components that need to be

          considered in order to determine the solvency control levels for a Takāful undertaking

          as a whole.

47.       The asset-liability matching policies for the PRFs and shareholders’ funds may be

          significantly different. The asset strategies adopted by a TO for the PRFs and the

          shareholders’ funds will be based on their respective financial liabilities profiles, and

          the need to ensure that the undertaking holds sufficient assets of appropriate nature,

          term and liquidity to enable it to meet the respective funds’ liabilities as they become

          due. In addition, part of the shareholders’ funds will normally be earmarked as a Qarḍ

          facility, and the assets financed by this part of the shareholders’ funds are to be

          counted for the purposes of meeting the capital requirements of the PRFs. An

          earmarked Qarḍ facility should generally be held in a form in which it may quickly be

                                                                                                            24

          drawn down in the form of assets appropriate to the PRF they are to back up . The

          analysis of types of risks for the shareholders’ funds and Takāful PRFs can be

          summarised as in Figure 2.

48.       As indicated in Paragraph 21 above, the basic objectives of solvency requirements

          are to provide assurance that:

          i.         On a probabilistic basis and taking account of the possibility of adverse

                     developments in all areas of risk to which the fund is exposed the PRF can

                     meet claims from Takāful participants; and

          ii.        The TO can meet its own financial and legal obligations, including the

                     possible need to provide capital by way of a Qarḍ facility to the PRF.

24

   The capital requirement will include an amount that reflects the riskiness of the assets held to support the

underwriting funds, including the assets of the underwriting funds and those financed by the Qarḍ facility.

                                                                                                               15


49.         The approach adopted is to:

            i.        Determine the economic value of the assets and liabilities; and to

            ii.       Calculate the additional capital required to offset the potential impact of each

                      of the identified components of risk.

50.         The assessment of the quantum of additional capital required for each risk

            component, and of the overall capital requirement should be through a modelling

            approach (whether using a standard model prescribed by the supervisory authority, or

            through the use of internal models approved by the supervisor). In either case, the

            model should test the ability of the fund, or of the operation as a whole, to meet its

            obligations with a defined level of probability (e.g. 99.5%) over a specified period (e.g.

                     25

            1 year) .

51.         The following table sets out the main risks to which the PRF and the Takāful operator

            are potentially subject. With the exception of liquidity risk, (for which a quantifiable

            and effective capital requirement is generally not an effective risk mitigant) these

            should be taken into account in determining the capital requirements for each of the

            funds. In the case of liquidity risk, the supervisor might impose a capital requirement

            depending on the extent to which the risk was considered to be effectively mitigated

            by asset-liability management.

25

   See Footnote 7 above. The The IAIS Common Structure Paper for Assessment of Insurer Solvency referred to in

"Structure Element 3" provides that: A solvency regime should address all relevant potentially material risks, including

underwriting risk, credit risk, market risk, operational risk and liquidity risk. All risks should, as a minimum, be

addressed by the insurer in its own risk and capital assessment.

   • Risks that are generally readily quantifiable should be reflected in sufficientlyrisk sensitive regulatory financial

     requirements.

   • For risks that are less readily quantifiable, regulatory financial requirements may need to be set in broad terms

     and complemented with qualitative requirements.

                                                                                                                     16


           Figure 2: Risks faced by the respective funds in a Takāful undertaking

              Categories of risks               PRFs                                 Shareholders’ funds

              Provisioning and

              Reserving Risks

              The risks of under-               General Takāful is exposed

              estimation of the                 to losses due to random

              underwriting liabilities and      events such as natural

              adverse claims                    perils, fire, pollution, crime,

              experiences                       war, terrorism, and others.

                                                Family Takāful is exposed

                                                to losses arising from

                                                severity and frequency of

                                                claims due to changes in

                                                anticipated mortality,

                                                morbidity and longevity as

                                                well as catastrophic events

                                                such as epidemic, major

                                                accident or terrorist attack.

              Underwriting

              Management Risks

              The risks of poor                 Family Takāful and General

              management of accepting           Takāful are exposed to

              risk and claim payouts            losses arising from poor

                                                selection, pricing and

                                                acceptance of risks and

                                                inappropriate product

                                                design.

              Credit Risks

              The risk of a counterparty        Exposed to profit and                Exposed to risk of non

              failing to meet its               capital receivables from             receipts of profit and

              obligations in accordance         invested assets, Takāful             capital receivables from

              with agreed terms                 contributions receivable             invested assets, Wakalah

                                                and Retakāful recoveries.            fee (due to contributions

                                                                                     receivable) and other trade

                                                                                              26

                                                                                     debtors

              Market Risks

              The risk of losses arising        The risks relate to the              The risks relate to the

              from movements in market          current and future volatility        current and future volatility

              prices i.e. fluctuations in       of market values of specific         of market values of

              values in tradable,               assets (for example, the             specific assets (for

              marketable or leaseable           commodity price of a Salam           example, the commodity

              assets (including Sukūk)          asset, the market value of a         price of a Salam asset, the

              and a deviation of the            Sukūk, the market value of           market value of a Sukūk,

              actual rate of return from        assets purchased to be               the market value of assets

              the expected rate of return       delivered to a Murābahah             purchased to be delivered

                                                customer over a specific             to a Murabahah customer

                                                period, the market value of          over a specific period, the

                                                Ijarah assets) and of foreign        market value of Ijarah

                                                exchange rates.                      assets) and of foreign

                                                                                     exchange rates.

26

   The risk of non-recovery of a Qarḍ which has been drawn down is a credit risk, but falls on the ‘earmarked’ portion

of the TO’s shareholders’ funds, which are not included in the TO’s capital for regulatory purposes.

                                                                                                                   17


       Categories of risks             PRFs                          Shareholders’ funds

       Operational Risks

       The risk of loss resulting      Loss of income from the       Administration and

       from inadequate or failed       purification of tainted       acquisition expenses for

       internal processes, people      income due to Sharī’ah        developing and

       and systems or from             rulings. Losses due to        maintaining the Takāful

       external events. Sharī’ah       claims fraud. Losses due      contracts. This relates to

       non-compliance risk             to legal risk (e.g. in court  the business risks whereby

       should also incorporate         interpretations of policy     the fund will not have

       possible causes of loss         terms).                       adequate cash flow to

       resulting from non-                                           meet the operating

       compliance and failure in                                     expenses.

       the TO’s fiduciary

       responsibilities                                              Also liable for losses

                                                                     arising from its negligence,

                                                                     misconduct or breach of

                                                                     fiduciary duties in the

                                                                     management of PRFs

                                                                     (fiduciary risk).

       Liquidity risk

       The potential loss to a         Additional costs through      Additional costs through

       Takāful undertaking arising     raising additional funds at a raising additional funds at

       from its inability either to    premium on the market or      a premium on the market

       meet its obligations or to      through the sale of assets    or through the sale of

       fund increases in assets        which simultaneously affect   assets which

       as they fall due without        the overall appropriate       simultaneously affect the

       incurring unacceptable          provisioning and reserving    overall appropriate

       costs or losses                 methodologies of PRFs.        capitalisation and

                                                                     reserving.

52. Hence, the general formulae for the solvency requirements for a Takāful undertaking

    could be as follows:

    For PRF:

    SR = RCPR + RCUR + RCCR + RCMR + RCOR where

    SR              =      Solvency requirement

    RCPR            =      Risk component for provisioning and reserving risk

    RCUR            =      Risk component for underwriting risk

    RCCR            =      Risk component for credit risk

    RCMR            =      Risk component for market risk

    RCOR            =      Risk component for operational risk

    For Takāful operator

    CR = RCCR + RCMR + RCOR where

    CR              =      Capital requirement

    CRCR            =      Risk component for credit risk

    CRMR            =      Risk component for market risk

    CROR            =      Risk component for operational risk

    In assessing the overall solvency requirement, due allowance may be made for the

    degree of correlation or diversification between the individual risk components.

53. With regard to the choice of the risk measure and confidence level to which solvency

    requirements for Takāful undertakings are calibrated, the supervisory authorities may

    set a confidence level for regulatory purposes.

                                                                                                  18


54.       Where the supervisory regime may allow the use of approved more tailored

          approaches such as internal models for the purpose of determining solvency

          requirements, the target criteria should also be used by those approaches for that

          purpose to ensure broad consistency within the solvency requirements as compared

          to those entities using a standard approach.27 The appropriate parameters and target

          criteria for these elements in the solvency framework should be outlined to provide

          clearer guidance to determine regulatory solvency requirements. Importantly, the use

          of these internal models must have prior approval from the supervisory authorities to

          ensure that the internal models are appropriately adjusted to the standard solvency

          requirements.

55.       The determinants of the risk exposures of the Takāful and the shareholders’ funds will

          reflect and may depend on the Takāful product structure and specification. For

          instance, in a single contribution mortgage reducing term Family Takāful, Wakālah

          fees are received mainly at the inception of the cover, whereas the administration

          expenses are expected to be incurred throughout the duration of the contract. In

          conventional insurance, the provisioning for conventional single premium of life

          insurance mortgage term assurance includes a provision for expense. Nevertheless,

          taking into account the conservative mortality assumption used, the actuary, who is

          responsible for advising on the valuation of the insurance liabilities, is likely to keep

                                                    28

          this expense provision minimal. However, for Family Takāful, the mortality and

          expenses provisions would need to be made in separate funds i.e. the mortality

          provisions are held within the Family PRF and its expenses provisions could be held

          against the shareholders’ fund. In this circumstance, the shareholders’ fund may need

          to hold adequate expenses provisions to cover the long term maintenance of the

          product.

56.       Another instance is the split of expenses between acquisition and maintenance. In

          conventional insurance, this split is typically based on the insurer’s judgement. If too

          many expenses are allocated to the acquisition category, then a forward looking view

          of the insurer’s on-going maintenance expenses will be understated. This may result

          in the under-provisioning of such expenses in the liabilities and an overly optimistic

                                                                29

          view of the insurer’s future financial condition. However, in a Takāful undertaking,

          especially Family Takāful, it is dependent on the product specification of the Takāful

          products. The identification of the split of expenses between acquisition and

          maintenance cost is essential to determine the computation of the solvency

          requirements for a Takāful undertaking i.e. whether the risk component for the

          expenses provisions of the acquisition and maintenance cost lies in the PRFs or the

          shareholders’ fund.

27

   Refer to the IAIS’s Guidance paper on use of internal models for risk and capital management purposes by

insurers.

28

   Refer to A Global Framework for Insurer Solvency Assessment A Report by the Insurer Solvency Assessment

Working Party of the International Actuarial Association

29

   Refer to A Global Framework for Insurer Solvency Assessment A Report by the Insurer Solvency Assessment

Working Party of the International Actuarial Association

                                                                                                        19


57. Each class of asset needs to be assessed in terms of its contribution to the risk profile

    of the undertaking. For example, supervisory authorities in a number of jurisdictions

    permit Takāful undertakings to invest in real estate. Real estate is widely regarded as

    a permissible asset class under Sharī’ah rules and principles. However, investments

    in real estate can be generally characterised as risky in terms of both potential market

    volatility and lack of liquidity, and this may pose significant risks to the PRFs in terms

    of meeting financial obligations or the ability of the TO to provide an effective Qarḍ

    facility. Hence, the supervisory authority may, in defining its solvency resources

    regime, impose restrictions on the type, level and concentration of real estate

    investment by the Takāful undertaking. These limits may be different for different

    types of Takāful, reflecting the fact that investment in real estate is likely to be less

    problematic in relation to long-term savings products in Family Takāful than in

    General Takāful. Alternatively, the supervisory authority may set capital charges in

    relation to real estate investment which recognises its risky nature through the capital

    requirements.

                                                                                            20


Key Feature 6: The adequacy of regulatory solvency requirements for a Takāful

undertaking depends on the maintenance of a sound risk management framework. An

essential part of the supervisory review process is to assess for each undertaking that

adequate risk management arrangements are in place through which the TO can, and

does, monitor, measure, report and control the management of the assets and

liabilities in a coherent and integrated manner.

58.        Takāful undertakings, and through them participants, can be exposed to the risk of

           financial loss, not only through underwriting and investment failures but through lack

           of liquidity, particularly in the event of unexpected volumes of claims or of withdrawals

           from, or surrenders of, family Takāful schemes. Moreover Takāful operations are

           also at risk from litigation, fraud, theft, lost business, and wasted capital from failed

           strategic initiatives. Losses from Takāful activities typically result from or are

           exacerbated by inadequate internal controls, weak risk management systems,

           inadequate training, or deficient board and management oversight. Maintaining a

           good reputation and positive public image is also vital to a successful Takāful

           business.

59.        While regulatory capital provides a buffer to absorb loss it is not a sufficient risk

           mitigant on its own.30 Accordingly a TO should have in place a comprehensive risk

           management framework and its reporting process, including appropriate board and

           senior management oversight, to identify, measure, monitor, report and control

           relevant categories of risks and, where appropriate, to hold adequate capital against

           material risks. The framework should allow appropriate steps to comply with Sharī`ah

           rules and principles and to ensure the adequacy of relevant risk reporting to the

           supervisory authority. In the context of its overall enterprise risk management

           framework, a TO should perform its own risk and solvency assessment (ORSA) and

           have risk and capital management processes in place to monitor and manage the

           level of its financial resources relative to its economic capital and the regulatory

           capital requirements set by the solvency regime.31 This is to mitigate the

           consequences of adverse events that may occur by taking early corrective measures

           intervention so that the solvency control level can be restored or an orderly exit can

           be arranged. The ORSA will help the TO and the supervisory authority in assessing

                                                                                                             32

           the need for any additional capital or draw-down of the Qarḍ facility to the PRFs. It

           should be undertaken at each level to which a solvency requirement applies. In

           particular, it should be undertaken for the PRF(s) and shareholders’ fund separately.

60.        As noted in paragraph 7 a PIF operated by a family Takāful undertaking is normally a

           pure investment fund in which the investment risks are borne fully by the participants.

           Accordingly it will not be exposed to risks arising in the PRF. Accordingly a PIF will

           not need to meet the capital requirements appropriate to a PRF, and no capital will

           need to be held, within either the PIF or an earmarked Qarḍ facility, for credit or

           market risk arising in relation to the assets held by the fund. But the TO’s risk

           management framework should nonetheless extend to ensuring the sound operation

           of the PIF. In particular assets should be held which are appropriate to the purpose

           for participants contributed to the PIF, and should be sufficiently liquid to allow for

           withdrawals and surrenders. In the event that the assets are not sufficiently liquid to

           meet demand for withdrawals and surrenders it is possible that a Qarḍ will need to be

           provided to allow the PIF to meet its liabilities as they fall due.

30

   Failure to put in place, operate and maintain an adequate risk management framework should result in a higher

capital requirement for both PRA and Takāful Operator through an increase in the operational risk component.

31

   Adopted from IAIS Guidance paper on the structure of regulatory capital requirements (October 2008).

32

   Refer to section 4 in the IAIS Guidance paper on enterprise risk management for capital adequacy and solvency

purposes (Oct 2008).

                                                                                                                21


61. Since the TO acts in a fiduciary capacity on behalf of the Takāful participants in

    performing underwriting and managing the PRFs as well as ensuring an adequate

    level of solvency in the both Takāful and the shareholders’ funds, it is the role of the

    board of directors of a TO and its senior management to provide reasonable

    assurance of effectiveness and efficiency of operations, reliability of financial and

    non-financial information, an adequate control of risks, a prudent approach to

    business and compliance with laws and regulations, and internal policies and

    procedures. In addition, the solvency requirements regime should place emphasis on

    the TO having appropriate controls in place and taking great care to ensure that all

    persons or entities with operational and oversight responsibilities act in the best

    interests of Takāful participants and beneficiaries.

                                                                                          22


Key Feature 7: Information regarding the solvency requirements for a Takāful

undertaking that is material and relevant to the market participants should be publicly

disclosed to enhance market discipline and the accountability of the TO.

62.    The existence of such an environment, where material and relevant information on

       solvency requirements for a Takāful undertaking is readily accessible, works as a

       strong incentive to TOs to conduct their business in a sound and efficient manner,

       including an incentive to maintain an adequate solvency position that can act as a

       cushion against potential losses arising from risk exposures. This will lead to more

       effective accountability and thus helps to safeguard the integrity of Takāful

       undertakings, as well as guiding potential Takāful participants in their decisions on

       whether or not to participate in a Takāful scheme. Adequate disclosure assists

       potential and existing Takāful participants, as well as other market participants, to

       evaluate the financial standing of Takāful undertakings and the risks to which they are

       exposed.

63.    Thus, disclosures regarding the solvency requirements should be subject to a

       requirement for public disclosure of adequate qualitative and quantitative solvency

       information, excluding commercially proprietary information and other information

       subject to confidentiality considerations to the Takāful undertaking. (These types of

       information, however, should be disclosed to the supervisory authority.) For public

       disclosure, a TO should describe the overview of the risk management framework for

       identifying, measuring, monitoring and controlling relevant risks in maintaining the

       solvency control level in its annual report.

                                                                                            23


DEFINITIONS

The following definitions are a general understanding of the terms used in this document. It is

by no means an exhaustive list.

Acquisition cost       Upfront costs incurred by a Takāful undertaking at the issuance of new

                       business such as commissions to sales agents, underwriting and other

                       acquisition expenses.

Asset-Liability        The on-going process of formulating, implementing, monitoring and

Matching               revising strategies related to assets and liabilities to achieve the

                       financial objectives, given the risk tolerances and other constraints.

Current central        The present value of probability-weighted cash flows expected to arise

best estimate          from PRFs’ portfolio of Takāful contracts considering all currently

                       available information.

Exit value             The net realisable value of an asset, i.e. its market price at the date of

                       a balance sheet less the selling expenses, or in the case of a liability

                       the amount for which it could be settled or transferred at that date plus

                       the costs of doing so..

Going Concern          The expectation that the Takāful undertaking will continue its

                       operations and take on new risks.

Internal Model         A risk measurement system developed by a TO to analyse its overall

                       risk position, to quantify risks and to determine the economic capital

                       required to meet those risks.

Liabilities            The financial obligations of both the shareholders’ and the PRFs.

                       Detailed descriptions are set out below.

                       i.    Liabilities of the shareholders’ funds are all financial obligations of

                             those funds, and do not include technical provisions which are

                             liabilities of the PRFs

                       ii. Liabilities for PRFs include financial obligations owed by the

                             funds particularly amounts payable to participants in respect of

                             valid expected benefits. In addition, PRFs’ liabilities include

                             technical provisions in respect of potential liabilities from business

                             already written.

Market consistent      A valuation of the PRFs’ assets and liabilities that is consistent with

valuation              either the assessment of their risk and value by market participants

                       (“mark-to market” valuation) or, in the absence of a direct market

                       evaluation, the valuation principles, methodologies and risk

                       parameters that market participants would expect to be used (“mark-

                       to-model” valuation).

Minimum Capital        The minimum solvency control level set for the PRF at which the

Requirements           supervisory authority would invoke its strongest actions, if corrective

(MCR)                  actions are not implemented.

Minimum Target         The minimum solvency control level set for the shareholders’ fund at

Capital (MTC)          which the supervisory authority would invoke its strongest actions, if

                       corrective actions are not implemented.

Muḍārabah              A contract between the capital provider and a skilled entrepreneur

                       whereby the capital provider would contribute capital to an enterprise

                       or activity that is to be managed by the entrepreneur as the Muḍārib

                       (or labour provider). Profits generated by that enterprise or activity are

                       shared in accordance with the terms of the Muḍārabah agreement,

                       while losses are to be borne solely by the capital provider unless they

                       are due to the Muḍārib’s misconduct, negligence or breach of

                       contracted terms.

                                                                                                   24


Own risk and       A Takāful undertaking’s assessment of the adequacy of its risk

solvency           management and current, and likely future, solvency position. Such an

assessment         assessment should encompass all reasonably foreseeable and

(ORSA)             relevant material risks, should identify the relationship between risk

                   management and the level and quality of financial resources needed

                   and available and should determine the overall financial resources the

                   Takāful undertaking needs to manage its business given its own risk

                   tolerance, business plans, and supervisory requirements.

Participants’      A fund to which a portion of contributions paid by Takāful participants

Investment Fund    is allocated for the purpose of investment and/or savings.

(PIF)

Participants’ Risk A fund to which a portion of contributions paid by Takāful participants

Fund (PRF)         is allocated for the purpose of meeting claims by Takāful participants

                   on the basis of mutual assistance or protection.

Provisions         The amounts set aside on the balance sheet to meet liabilities arising

                   out of Takāful contracts, including provision for claims (whether

                   reported or not), provision for unearned contribution, provision for

                   unexpired risks, Takāful provision, and other liabilities related to

                   Takāful contracts (e.g. contributions, deposits, savings accumulated

                   over the term of Takāful contract).

Prescribed Capital The solvency control level set for the PRFs which, if breached, would

Requirements       require action by the TO to increase its solvency resources or reduce

(PCR)              the risks undertaken by the PRFs.

Prescribed Target  The solvency control level set for the shareholders’ fund which, if

Capital            breached, would require action by the TO to increase its capital

(PTC)              resources to meet its financial obligation.

Prudent person     The ‘prudent person’ approach requires the TO to act in the way that a

Rule (PPR)         prudent person would, e.g. by considering the risks involved, obtaining

                   and acting upon appropriate professional advice and suitably

                   diversifying the investments.

Qarḍ               A non-interest-bearing loan intended to allow the borrower to use the

                   funds for a period with the understanding that this would be repaid at

                   the end of the period.

Quantitative       Specific limits on holdings in risky asset classes imposed by the

Restrictions       supervisory authority.

Reserves           Amounts set aside to meet unforeseeable liabilities or statutory

                   requirements and stemming either from shareholders’ capital or from

                   accumulated surplus.

Risk weightings    The assigning of greater importance to particular assets or liabilities

                   based on the risk profiles.

Risk management    The process whereby the Takaful undertaking's management takes

                   action to assess and control the impact of past and potential future

                   events that could be detrimental to the undertaking. These events can

                   impact both the asset and liability sides of the undertaking's balance

                   sheet, and its cash flow.

Risk Margin        The component of the PRF’s technical provisions that reflects the level

                   of risk and uncertainty in the determination of the current estimate and

                   produces a technical provision that reflects the value that another TO

                   would be expected to require in order to take over (hypothetically) the

                   portfolio of obligations.

Run-off            The situation where a TO no longer undertakes new business for a

                   PRF but continues to meet the fund’s obligations in respect of in-force

                   Takāful contracts until the end of their terms, including benefits arising

                   from those contracts.

Solvency Control   Levels of regulatory solvency requirements which, if breached, trigger

levels             restrictions on the TO or interventions by the supervisory authority.

                                                                                             25


Solvency            The financial requirements that are set as part of the solvency regime

Requirements        and relate to the determination of amounts of solvency resources that

                    a Takāful undertaking must have in addition to the assets covering its

                    technical provisions and other liabilities.

Solvency            The surplus of assets in excess of liabilities that is regarded as

Resources           available for solvency requirements, in accordance with domestic law

                    or supervisory regulations.

Tabarru’            The amount of contribution to be relinquished by a Takāful participant

Commitment          as a donation for fulfilling the obligation of mutual help and to be used

                    to pay claims submitted by eligible claimants.

Takāful             Takāful is derived from an Arabic word which means solidarity,

                    whereby a group of participants agree among themselves to support

                    one another jointly for the losses arising from specified risks. In a

                    Takāful arrangement, the participants contribute a sum of money as

                    Tabarru’ commitment into a common fund, which will be used for

                    mutual assistance of the members against specified loss or damage.

Takāful participant A party that participates in the Takāful product with the TO and has the

                    right to benefit under a Takāful contract (similar to a “policyholder” in

                    conventional insurance).

Takāful operator    Any establishment or entity that manages a Takāful business.

(TO)

Takāful             A hybrid structure comprising a Takāful Operator (TO) and one or

undertakings        more underwriting funds (PRFs) that are attributable to the Takāful

                    participants.

Time horizon        The period of time over which the adequacy of solvency resources is

                    measured. For solvency purposes this is often set to approximate the

                    length of time that a Takāful undertaking or a supervisory authority

                    would reasonably need in order to take effective action after the

                    revelation of an adverse event in a Takāful undertaking’s internal or

                    regulatory reporting. The time horizon is part of the target criteria in the

                    calibration of regulatory solvency requirements.

Technical           The value set aside to cover expected obligations arising on Takāful

Provisions          contracts. For solvency purposes, technical provisions comprise two

                    components, namely the current central best estimate of the costs of

                    meeting the Takāful underwriting obligations, discounted to the net

                    present value (current estimate), and a margin for risk over the current

                    estimate.

Total balance       An approach to assessing the overall financial position of a Takāful

sheet               undertaking that recognizes the interdependence between the risks

approach            associated with a Takāful undertaking’s assets, liabilities, regulatory

                    solvency requirements and solvency resources and the potential

                    impact of those risks upon the Takāful undertaking’s balance sheet.

Underwriting        The process of evaluating new applications, carried out by a TO on

                    behalf of the Takāful participants based on an established set of

                    guidelines to determine the risk associated with an applicant. The TO

                    could accept the application or assign the appropriate rating class or

                    decline the application for a Takāful contract.

Underwriting        The PRF’s financial outturn from the risk elements of its business,

surplus or deficit  being the balance after deducting expenses and claims (including any

                    movement in provisions for outstanding claims) from the contribution

                    income and adding the investment returns (income and gains on

                    investment assets).

Wakālah             An agency contract where the Takāful participants (as principal)

                    appoint the Takāful operator (as agent) to carry out the underwriting

                    and investment activities of the PRF on their behalf.

                                                                                               26


                                                                              APPENDIX

                             INTERVENTION CONTROLS

                  Breaches the

                                        Between the PTC /PCR

              PTC/PCR but above                                      Below the MTC/MCR

                                         and MTC/MCR level

                MTC/MCR level

Supervisory  • Request for a            • Closely monitors the      • Take actions to

authority      restoration plan from       implementation by           protect the interest of

               TO                          the TO including            the Takāful

             • Continuous                  requisition of              participants

               discussion with the         evidence that actions

               TO as to the reason         have been

               for the breach and          implemented

               the potential for

               corrective measures

Takāful      • Formulation of a         • Implement the agreed      • Take actions to

operator       restoration plan            corrective measure          protect the interest of

             • Continuous dialogue         and closely monitor         the Takāful

               the supervisory             for adjustment              participants

               authority to justify the

               breach and the

               potential for

               corrective measures

Possible     • Restoration plan         Between the PCR and         For breach of MCR

Intervention   which include:           MCR level

actions        ► Reason of the          • Restoration plan          • further draw-down of

                    breach                 which includes a            the Qarḍ facility to

               ► Potential                 proposed timeline for       the PRF; or

                    corrective             improving the            • Plan for run off of the

                    measures               solvency level with         PRF, or transfer to

               ► a proposed                and without the draw-       viable third party

                    timeline for           down of the Qarḍ

                    improving the          facility.

                    solvency level      • Draw down of the

                    with and without

                                           Qarḍ facility to the

                    the draw-down of

                                           PRF in order to

                    the Qarḍ facility.     expedite the

                                           restoration of the

                                           PCR level

                                        • TO may not be

                                           allowed to undertake

                                           new business for

                                           PRF

                                        Between the PTC and         For breach of MTC

                                        MTC

                                        • initial capital injection • further capital

                                           could be required           injection into the

                                                                       shareholders’ fund or

                                                                       transfer to viable

                                                                       third party

                                                                                        27