takaful MODELStakaful could in theory be embed by administratives or by privately organised groups. In real, given the range of risks that requires covering and the fact that different risks apply to different groups of people, it is difficult for system to provide the compulsory range and depth of coverage. Therefore takaful solutions have tended to be set by private organisations.Single entity structureA single non-profit body can be set up on a mutual or communal basis. This is almost similar to a mutual organisation in the United Kingdom, in which the entity is owned by members and there are no external shareholders seeking to make a profit from its activities. Members appoint a board or management to run the operation. The cost of management and other expenses are funded through member contributions and other activities such as profits earned from investments. Any excess, net of claims paid and expenses, belongs to members. Any shortfall needs to be covered by increased contributions from associates.Double entity structure A two-tier structure of takaful operation is:Entity 1: a takaful mutual fund/pool operating on a non-profit basis to collate members’ funds and pay out to them on the incidence of certain events covered by the fund. The monies in the pool, including any surplus, belong to the members.Entity 2: a commercial entity, usually referred to as the takaful operator , engaged by the takaful fund to manage activities such as claims handling and investments in accordance with sharia principles. The commercial entity is motivated by the revenues it can earn for shareholders from services provided to the takaful non-profit-making entity. The TO has no direct liability in respect of any takaful policies issued by the fund – it is merely entrusted to manage the takafulentity and its investments.A common feature of the relationship between the TO and the takaful fund is that the operator agrees to provide an interest-free loan to the fund in the event of a shortfall in the fund due to claims exceeding member contributions.Possible pitfalls of the double entity structureMost takaful operations around the world have been set up based on the double entity structure, and have usually been initiated by takaful operators who have identified a commercial opportunity in providing sharia-compliant protection.There are some potential pitfalls with this structure:takaful is in essence a non-profit-making activity, set up for the mutual protection and benefit of its members. The takaful fund must ensure that its original purpose and values are not undermined by the involvement of a commercial entity focused on maximising profit. Close attention needs to be paid to how the commercial entity is remunerated, so that its interests are fully aligned to those of the takaful fund. We will look at this more closely when discussing how the relationship between the TO and the takaful fund can be structured.Some commentators have argued that the agreement by the TO to provide an interest-free loan to the takaful fund in the event of a shortfall is tantamount to transferring risk from the takaful fund to the TO. Such a transfer would be fundamentally at odds with the concept of takaful – that risk needs to be shared and distributed among members of the takaful fund and not transferred to a third party.Relationship between the takaful pool and the takaful operatorAs described above, the operator provides services to the pool. These services fall into two broad categories:Underwriting – this includes issuing new takaful policies and claims handling. These services are typically provided by the operator to the pool through a wakala contract (principal–agent relationship). The operator acts as the agent (wakil) of the pool members (the principal) and receives a fee for its underwriting services on this basis. This can be structured as a fixed fee or as a percentage of the contributions paid into the pool.Investment management – this refers to investing the monies of the takaful pool on behalf of the pool members. A mudarabah contract for the investment management services is typically provided by the operator. The operator acts as the mudarib, providing investment management services to the pool members, who collectively form the rabb-ul-maal (providers of capital). Under such a contract, the operator does not receive any fixed remuneration, instead sharing in any profit generated through the investment activity, while any losses are borne solely by pool members.The wakala contract for underwriting services and the mudarabah contract for investment management services is the most common model used to define the relationship between the TO and the takaful pool and its members. There are a number of reasons for this:The wakala contract lends itself well to the provision of underwriting services as a management fee is charged to the pool by the TO. This is usually either a fixed fee or a percentage of the value of contributions received by the pool (this can be justified on the basis that the greater the value of contributions, the more work the operator needs to do).Applying a mudarabah (profit-sharing) contract to underwriting would not work as well for the following reasons:The essence of takaful is that any underwriting surplus should belong to the pool members, as they are and should be the ‘risk takers’. If the operator shares in the surplus, its role as a ‘risk manager’ starts to merge wrongly into ‘risk taking’.An underwriting surplus is not the aim of the takaful pool and is not the same as a profit – it is in fact an undistributed surplus from the tabarru. Hence to apply a contract of profit sharing is something of a mis-fit.Similarly, if the operator is remunerated according to the value of the underwriting surplus, the operator will be motivated to maximise the surplus. This is not aligned to the interests of the pool members, nor is it compatible with the aims and values of takaful.Yet the mudarabah contract is well suited to the investment management activities of the TO. The operator receives a share of any profits from the investments and hence the operator’s interests are generally aligned to those of the pool members – to make the best possible return. However, there is the potential misalignment of interests if the operator wants to take more risk than is suitable for the pool members. Such issues need to be addressed in the governance applied to takaful operations.Nevertheless, it is also possible to use a wakala contract for investment management services, instead of the mudarabah contract. The fee payable to the operator (wakil) can be structured to contain a performance-related component. The mudarabah contract is generally more risky from the operator’s point of view as no remuneration will be received unless a profit is made on the investments. Hence either wakala or mudarabah contracts could be used for investment management services: the contract chosen depends on the preferences of, and agreements between, the TO and the pool members.