Maria Kielmas looks at the expansion of global Islamic financial institutions and the challenges involved in addressing the needs of customers, regulators, liquidity and jurisprudence

The past three years have witnessed what appears to be a formidable expansion of insurance and reinsurance companies which operate in compliance with Islamic law, Shari'a. Known respectively as takaful and retakaful, these institutions hope to address the needs of customers throughout the Islamic world as well as those of Muslim communities in Europe and North America. The demand for such ethically-based products has been growing at between 15-20% annually, depending on the market.

No complete figures for the re/takaful market exist. But according to Omar Clark Fisher, formerly division manager for corporate business development at Takaful Ta'awuni, Bank Aljazira in Saudi Arabia, global takaful premiums in 1998 were $500m. He expects that this could have the potential to rise to $7bn in gross written premiums by 2015. But he urges a cautious approach to the latest phase of re/takaful expansion.

"There is definitely real growth, more capacity and from a consumer point of view more choices," he says. "But there seem to be more companies without a carefully defined business plan. This could be a risk to the market, particularly in retakaful, and it's not obvious what the outcome will be." Re/takaful operations have opened and closed in recent years in the Gulf Co-operation Council (GCC) countries without any apparent business purpose, raising suspicions that they had been used in money laundering operations, Mr Fisher adds.


He believes that, while there was a dearth of retakaful capacity four or five years ago, the word seems to have gone around that this sector was a new business opportunity. New players have piled into the market in a manner reminiscent of the expansion of conventional reinsurance in developing countries during the 1970s. The real need is for a couple of retakaful companies with massive capital, believes Mr Fisher. Average capitalisations of retakaful players are between $10m and $50m compared with many billions in the case of conventional reinsurers. New entrants into the retakaful market, such as Methaq Re, a Bahrain-based joint venture between Saudi, other Gulf Arab and European capital, has only a paid up capital of $2.6m. The Bahraini and Sudanese governments are discussing the creation of Takaful Re, but local experts doubt that this will be much larger than the current average. Even the largest retakaful company, Labuan, Malaysia-based Asean Retakaful International (ARIL), will only have a paid up capital of $50m by 2007.

As a result, takaful companies generally retain some 15-40% of their business or reinsure with conventional reinsurers, a dispensation allowed under Shari'a law because of the lack of alternatives. But this creates a significant credit risk in the entire re/takaful sector, believes Martin Mandabady, formerly of London-based law firm Norton Rose but from October head of the corporate insurance team at London law firm Lawrence Graham.

"Retakaful has not really taken off," he says.

The real reason for this, thinks Omar Clark Fisher, is the lack of Shari'a- compliant long term investment vehicles for the re/takaful sector. This in turn underlines the need for a more careful approach to Shari'a scholarship and greater supervision from regulatory authorities.

Shari'a scholars first declared conventional insurance forbidden (haram) in 1903, stating that it contravened Islamic law which forbids interest (riba), gambling (maisir) and uncertainty (gharar). Since then two divergent opinions have developed among Islamic scholars. The first argues that insurance is forbidden because it is based on betting, is of an uncertain nature and is an attempt to supersede the will of God. The second is held by a modernist group which argues that insurance has none of the forbidden three elements and that it can operate through interest-free channels.

Slow beginning

The result has been the slow creation of Islamic finance, first in the form of a savings bank in 1963 in Egypt, the intergovernmental Islamic Development Bank (IDB) in 1974 to provide project and trade finance, and the first takaful company in 1974 in Sudan. The real impetus was provided by Malaysia in 1984 with the approval of the Takaful Act which was followed by the launch of the most imitative Islamic financial products. Even so, only 27% of the Malaysian re/insurance market is covered by re/takaful operators.

The next milestone will be the adoption of a new regulatory framework for re/takaful in Bahrain. Bahrain Monetary Authority (BMA), the financial regulator, issued a final version of its consultation paper on re/takaful regulation in late July this year. The aim is to clarify the regulatory position of re/takaful firms, ensure they meet regulatory objectives, and to align re/takaful regulation as reasonably as possible with its proposals for conventional re/insurance. Re/takaful regulation will be conducted through rules which are broadly consistent with international insurance standards, the BMA paper states. (see box)

Schools of jurisprudence

A Shari'a supervisory board is required for all re/takaful companies.

This rules on the compliance or otherwise of each product. Such rulings can vary widely as there is no central authority in Islam. In addition to the Sunni and Shia division, other groups in the Islamic world are the Ahmadis, Sufis and Salafis. Sunni Islam has four schools of jurisprudence while the Shia has three. This has led to disagreement on the nature of Shari'a compliant products offered by companies in the Far East, which generally follows the Sunni Shaf'i school, and the Arab Gulf, which follows the Sunni Hanafi school. Thus in December last year when the Munich-based FWU Group and the Dubai Islamic Insurance and Reinsurance Company (AMAN) announced a co-operation agreement to offer life takaful products, a joint statement also added that "we are the first to offer a truly Shari'a compliant retakaful scheme."

AMAN managing director Hussein Mohamed Al Meeza explains that this statement came about after his company's Shari'a board had examined products on offer from Malaysia and deemed those non-compliant.

A question of interest

But differences within interpretations of Islamic jurisprudence are at the heart of the matter, namely the definitions of interest (riba) and uncertainty (gharar). The late Ibrahim Shihata (d.2001) an Egyptian international lawyer who was Secretary General of the World Bank's arbitration tribunal, ICSID, and a founder father of its investment guarantee division Multilateral Investment Guarantee Agency (MIGA), noted in his writing that the Arabic word riba has a much broader meaning than just interest on loans, which in any case did not exist 14 centuries ago when the primary sources of Islamic law, the Koran and the Sunnah, were written. The primary sources also show that co-operative risk sharing was practised at this time for long distance trade via caravans or sea voyage. The definition of riba is one of the most complex in Islamic jurisprudence and may cover cases of illegal enrichment in trading or lending, to ensure fairness in the conduct of business as well as the protection of weaker parties. "This cannot automatically suggest, however, that every possible barter trading in fungible commodities and every financial instrument that has a fixed return is tainted by riba," Shihata said. He added that "it is not clear how properly regulated and supervised banking operations can constitute riba or gharar or suffer from the underlying factors that justified the prohibition of these two condemned phenomena."

The lack of transparency in financial Islamic institutions has led to a reluctance on the part of Muslim communities in Europe and North America to buy their products. Expansion of all insurance products in the Middle East has been hampered by a lack of understanding of the business among the majority of the populations, notes Mr Al Meeza. And according to Abdul Rahim Abdul Wahab, executive director at Karachi-based accountants Sidat Hyder Morshed Associates, the take up of insurance has been hampered by the lack of effort on the part of the insurers, the concentration of core business in major cities, a lack of trust on the part of consumers about the companies' claims paying abilities, as well as antipathy to insurance on religious grounds.

Need to expand Shari'a dialogue

Omar Clark Fisher thinks there is a pressing need to expand the scope of Shari'a dialogue to address matters such as risk securitisation and other innovative products, as well as providing a scholarly consensus on takaful products which are sensitive to regional differences. This has to be combined with an increase in the professional expertise in modern capital markets. He acknowledges that organisations such as the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOFI) have made great progress in defining internationally acceptable standards for Islamic finance. "This can only help to overcome scepticism on the part of consumers," he says. But a harmonisation of ruling (fatwas) by Shari'a boards is the critical issue facing the global Islamic finance industry and something which the institutions are now calling for.

However, ultimately Islamic financial institutions cannot expand unless there is an efficient capital market system in which to operate. Many Islamic financial institutions place their surplus funds with western banks through Murabaha (a form of Islamic financing) trading on the London Metal exchange. But these are largely bilateral trades and counterpart limits pose a problem, notes Warren Edwardes, CEO of London-based consultancy Delphi Risk Management. There is nothing that can handle a multi-billion dollar market.


The development of Shari'a compliant bonds known as sukuk has been hailed as the beginning of an Islamic capital market. The first such bond issued out of Europe was a EUR100m bond issued by the state government of Saxony-Anhalt in Germany. According to issue manager Noriba Bank, a division of Swiss UBS, it is based on a sale (to a special purpose vehicle) of a leaseback (to Saxony-Anhalt) of certain previously state-owned real estate assets. The return is derived from the rents paid to it under leases by the state.

But even though recent sukuk issues have been oversubscribed, most of this paper is bought to hold rather than to trade. Edwardes believes that this creates a problem both on sale, price determination and market-to-market, partly as a consequence of the view that debt trading is not Shari'a compliant. Many Islamic finance experts are echoing the earlier views of Ibrahim Shihata that if Islamic law is to be applied to financial institutions, "due attention should be paid to the need for continuous adaptation of its jurisprudence to the necessities of development in an ever changing world."

Operating models

Takaful is based on the concept of Ta'awun, or mutual assistance.

This sets out to provide the services offered by a conventional insurer but in a co-operative manner consistent with Shari'a principles. The concept involves the payment of contributions that are wholly or partly donated from an insurance portfolio. The pooled resources are then used to pay the indemnity when a loss occurs. The two most common operating models are:

- The Al Mudharaba model. This is a profit sharing model where investors and policyholders provide capital and contributions respectively. The contract specifies how the profit (surplus) from operations is shared.

The arrangement general allows the operators and shareholders to share in both the underwriting results as well as investment yields.

- The Al Wakala model. In this model the policyholders pay contributions to the takaful fund. These include the payment of fees and charges due to the operator together with a donation to the takaful fund. All risks are borne by the fund and the annual operating surplus belongs exclusively to the policyholders. The operator does not share directly either in the risk or any surplus or deficit, instead receiving a managing fee which could include a performance fee based on any surplus.

The BMA has proposed that the only model acceptable in Bahrain is the Al Wakala model. This is followed in other Gulf states, is favoured from a regulatory perspective and ensures a common undertaking of takaful is developed in the market and the minds of consumers. The BMA has included transitional rules for those operators currently using the Al Mudharaba model.

The BMA does not propose to establish the precise rules as to what constitutes a Shari'a compliant product. This will be left to each company's supervisory board. But the BMA has decided that an insurer will only be permitted to carry takaful business if it is a pure takaful firm.

- Maria Kielmas is a freelance journalist and consultant.