LITERATURE REVIEW

In the beginning of 1970s until 1990s, Islamic countries and other countries with a
significant Muslim population around the world have encouraged the provision of financial
services, including insurance, under Islamic principles. Correspondingly, several Islamic
insurance companies, called takaful insurers, have been established in order to provide
Muslim individuals and businesses with insurance coverage both in the life and non-life
sectors. In fact, these insurers are found not only in Islamic countries and other countries
with a significant Muslim population. They are also found in North America, Australia and
some European countries. This type of modified cooperative insurance mechanism is
expected to further influence the supply and demand for insurance in the Muslim
community. Yet, no further studies have been conducted regarding the application of
Islamic principles into insurance and how this type of insurance arrangement works.

Subsequently, Maysami and Kwon (1999) were come up with the idea regarding the
issue above. They studied four important aspects for Islamic insurance namely, (1) Islamic
socioeconomic principles applied to insurance, especially regarding the concepts of
uncertainty, interest and investment arrangements; (2) described the basic structures of
takaful life insurance, non-life insurance and reinsurance; (3) investigated takaful insurer
operations in selected countries; and (4) discussed existing regulations as well as
suggestions for better takaful insurance operations through a detailed study.

It is worth prominent that the issues relating Takaful has always been discussed
especially regarding the family Takaful all over the world. Obviously, from the previous
study, the concept of modern Takaful has been studied and believed to be started in 1979
(Farooq, Chaudhry, Alam and Adam, 2010). Despite of its continuous growth, many
Muslim scholars argued that the conventional insurance does not fulfill the Syari’ah ethics
(Mohammad, 1988). They believed that conventional insurance system allowed fasid
(corruption) because of the contracts are engaged with gharar (uncertainty), maysir
(gambling) and the investment if premiums are riba-based (interest) (Farooq et al. 2010).
Apparently, the world is experiencing a vigorous Takaful industry and Malaysia is not an
exception to this evolution. In Malaysia’s perspective, the mudharabah model has emerge
as the earliest family of Takaful as it is known as profit-sharing or the surplus sharing
model (Yassin and Ramly, 2011). Under this model, Wakalah fee is charged upon the
contribution and the Mudarabah on the investments (Frenz & Soualhi, 2010; Frenz, 2009;
Ali, Odierno & Ismail, 2008).

The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)
defines mudharabah as a partnership in profit whereby one party provides capital and the
other party provides labour. Any profit is shared between the capital provider and
manager in accordance with a profit-sharing ratio agreed upfront. Any financial loss will be
borne solely by the capital provider, unless the loss is due to the manager’s negligence
(taqsir), misconduct (ta’addi), or a breach of terms (mukhalafah al-shurut). However, some
Takaful operators in Malaysia modified the mudarabah model by sharing the net
underwriting surplus (Ali, Odierno & Ismail, 2008).

Currently, there are two models in practice for any Takaful product in Malaysia either
Mudarabah model or Wakalah model. However, the hybrid wakalah model or Modified
Wakalah Model has been choosing by the Board of Director (BOD) and the Shari’ah
Committee of the Takaful Operators (TO) (Sheila and Zaharin, 2012). The main reason is
because the model is less controversial compared to the Mudarabah model (Sheila and
Salman, 2013). They do not use the Mudarabah model for managing the Family Takaful
Product mainly because most of Shari’ah scholars believe that the Mudarabah model
contradicts to the original form of Mudarabah contract (Salman, 2014). Subsequently,
most of Shari’ah scholars have agreed that the Mudarabah model is not suitable because
it includes in the condition that the expenses of managing the fund is paid from the
Mudarabah capital which is the Takaful contributions from the participants. Hence, the
Mudarabah become invalid. Sheila and Zaharin mentioned that, the reason for invalidity is
that, the expenses might be more than the profit in which case the expenses will have to
be covered from the Mudarabah capital which is the Takaful contributions itself. Therefore,
defeating the whole purpose of Mudarabah. Thus, Wakalah Model contains
lesser gharar as compared to the Mudarabah model because the portion of expenses is
charged under the upfront Wakalah fee (Sheila and Zaharin, 2012).

Apart from that, it is also understood in the Mudarabah contract that an entrepreneur
is liable to share the profit with the capital provider. According to Yassin and Ramly
(2011), a profit is considered profit if the entrepreneur manages to generate more than the
provided capital. Essentially, a mudarabah investment of 200 is only considered profitable
if the entrepreneur successfully brings in more than 200. However, that is not the case in
Takaful whereas, the surplus shared is net of claims, reserves, retakaful and expenses
(Frenz, 2009). According to Sheila and Zahirin (2012), they mentioned that the
interviewees opinion that the surplus shared between the participants and the Takaful
operators cannot be considered as a profit as it has nothing to do with the definition of
profit maintained in the principle of Mudarabah.

The other reason that the Modified Wakalah model is much preferred in Malaysia for
managing the Family Takaful product is because unlike the General Takaful business, the
Family Takaful business is long term in nature. And in the first few years of any business,
it is normal to expect little or no profit at all. So, Modified Wakalah model is seen very
appropriate for managing the Family Takaful product because it gives greater advantage
to the Takaful Operators and customers (contributions takaful). The benefit of upfront
Wakalah fees earned by the Takaful Operators give them greater opportunity to survive in
the beginning years of managing the Family Takaful product (Sheila, Jawahir and Salman,
2013).

The surplus (profit) of the underwriting in the participants’ special account (PSA) is
absolutely shared between the participants and the shareholders and this practice is
mentioned in the contract. The Takaful Operators believed that the ratio depends on the
type of product (The Family Takaful product has variety of options and categories).
However, this issue supported by the study conducted By Sheila and Zahirin (2012) where
the interviewees included that most participants are unaware of this situation because
they do not read the contract and are lack of understanding about the whole product.

Another main component of the modified mudharabah model is the interest free loan
(qard hassan). This component has also drawn some controversial issues. In his context,
the shareholders are obliged to provide interest free loans to the participants in the event
of any deficit in the participants’ special account (PSA) fund. This practice has been
discussed and mentioned in the Shari’ah Resolutions in Islamic Finance issued by the
Bank Negara Malaysia as one of the mechanisms to overcome deficit in the PSA fund.
However, according to Sohail (2007), the terms and conditions of qard hassan in terms of
repayment and timing of the drawdown are not certain and clear. On the other hand, there
is difficulty on how to maintain fairness among the different generations of participants
(Ismail, 2011). This is because of the new participants may be negatively affected by
paying higher contribution or receive small or even no underwriting surplus due to the
need of making repayments of qard hassan.
 It must be noted that the setting of contribution levels must not result in a higher fee,
otherwise this will defeat the purpose of qard hassan as a benevolent or interest free loan.
Besides that, the recent study conducted that Muslim scholars do not agree with the issue
of qard hassan implemented in the modified mudharabah model (Sheila and Zaharin,
2012). The study also found that takaful operators are choosing the models in order to
increase their self-interest, rather than the interest of the participants. Apart from that, one
common issue in relation to qard hassan is the misinterpretation of its concept (Atan,
2009). Since qard hassan is a benevolent loan, it means that under this original principle,
the borrower cannot be forced to make repayment. In the event the borrower is unable to
settle the loan, the lender must accept this transaction as a charitable act. In the context
of takaful, this is the main reason why some shareholders are quite reluctant to offer qard
hassan when there is deficit in the takaful fund.

Besides that, the issue of gard hassan also affect the acceptance of muslim
scholars towards Mudarabah model in managing the Family Takaful fund. It is identified
that if there is a case of deficit in the Family Takaful Fund, the Takaful Operators must
give qard hassan loans to the participants. According to Sheil and Zaharin (2012), based
on their findings, the interviewees strongly believe that the practice of mudharabah model
is obviously against the nature of Mudarabah because the main principle endorsed in the
Mudarabah contract is to share both the profit and loss. Therefore, profit should be shared
as agreed upfront by both parties and losses should solely be borne by the capital
provider not the entrepreneur. At the same time, they also admit that participants are not
fully ready to embrace the original concept of Mudarabah. Hence, Takaful Operators are
given no choice but to come out with their own fund to cover the deficit so that participants
do not withdraw from the Family Takaful Funds.

ISSUES IN MODIFIED MUDHARABAH TAKAFUL MODEL

Towards the practice of the modified mudharabah model takaful family in Malaysia, there
are several issues arising. The crucial issue is involving the muslim scholar in terms of
uncertainty in sharing the profit between the issue is whether the net underwriting surplus
can be treated as mudharabah profit. This is one of the fundamental issues in the
modified mudharabah model. As mentioned earlier in the previous study, the main
component in modified mudharabah model is to share underwriting surplus between the
takaful operator and participants. This approach has received several criticisms
particularly by Middle Eastern scholars and Islamic jurisprudents. The main reason for
adopting this practice is due to the low profitability and slow growth as well as less
feasibility of the pure mudharabah model (Ali et al. 2008). As long as the Takaful in pure
mudharabah is practice, the only main source of income for takaful operators is the profits
generated from the investment activities using the funds allocated in PA and PSA. Sohail
(2007), stated that the justification given for the practice of sharing underwriting surplus in
the modified mudharabah model is based on the grounds that such an arrangement would
grant takaful operators to cope up the competition with its conventional counterpart and
avoid overpricing. The study also validates that there is no explicit Shari’ah principle that
prohibits such a practice. Indeed, surplus sharing be an incentive for the takaful operator
for their hard work and relentless commitment in managing the takaful.

Other issues involving modified mudharabah model is the use of tabarru concept in
takaful creates another subsequent issue, namely the issue of underwriting surplus from
tabarru fund. The main issue in this context is whether the takaful operator is entitled to
have a share in the underwriting surplus or whether the surplus is exclusively owned by
the participants only, thus it should be redistributed back to them. In order to
comprehend this issue further, the research will now provide the definition of underwriting
surplus from two separate Islamic bodies, namely AAOIFI and Islamic Financial Services
Board (IFSB).

Besides that, Wakalah fee (agents' commission) is usually charged in advance as

upfront charge when participant pays contribution amount. According to accrual principle
of accounting, Wakalah fee will be earned at the end of Takaful period for a particular
year. Takaful operators claim that participant's contribution will be refunded whenever he
wants to withdraw the contract. Only Wakalah fee is deducted from the contribution
amount. The question arises if any participant withdraws his contract at the mid of Takaful
period. Has Takaful operator any right on unearned Wakalah fee or vise versa. If not, then
there should be a solution in every question of Wakalah fee whether its should be
returned to the participant when Takaful operator deducts. Otherwise, it should be pays to
Takaful agents as commission.

RECOMMENDATION

This study features the practice of modified mudharabah model for family takaful products
in Malaysia. Based on the previous study, it is asserts that the modified mudharabah
model is yet to prove that it is the best model for all affected parties. The unfavorable
Shari’ah and ethical issues should be resolved as soon as possible, and the regulators
should improve the existing model or introduce or recommend a new model to reflect the
concept of donation and mutual help.

In order to respond the arising issues, the Shari’ah Advisory Council of Bank
Negara Malaysia (SAC) has passed the resolution which allows the distribution of the
surplus from the participants risk fund between the participants and takaful operator. This
decision is because the takaful contract is generally formed on the concept of tabarru
(donation) and ta`awun (cooperative), as well as the mutual agreement between the
contracting parties. Apart from that, the tabarru principle is the basic principle of the
takaful product, meanwhile the mudharabah contract is applied in the management of
Takaful operation. While, Shari’ah Advisory Council (SAC) viewed the distribution as a
performance fee for the takaful operator. Besides that, the participant’s approval to share
the risk fund surplus with the takaful operator as the fund manager does not contradict
with Shari’ah principles. Nevertheless, the opponents of sharing underwriting surplus put
forward their argument that the practice of treating net underwriting surplus as
mudharabah profit is not in line with the definition of profit according to the original
mudharabah contact. It contradicts the general mudharabah rules (Ali et al. 2008).
Moreover, it is also stated that sharing of the underwriting surplus is commensurate to
making takaful into a commercial business venture instead of a contract that is based on
brotherhood solidarity and mutual co-operation (Yusof, Ismail and Naim, 2011).
Mudharabah profit can be defined as a surplus over and above the general capital after
deduction of costs and expenses. In this condition, there is usually no surplus over and
above the original capital because of the reduction due to claims or other expenses. The
remaining part is only the net underwriting surplus, which is lower than the original
mudharabah capital even after addition of any profit generated from the investment
activities. Furthermore, the AAOIFI Standard on takaful does not allow the takaful
operators to share underwriting surplus as they believe the underwriting surplus
exclusively belongs to the participants. Due to this endless debate, the majority of takaful
operators in Malaysia have now opted for the wakalah model after applying the
mudharabah model for more than two decades (Younes, 2008).

The difference between mudharabah model and modified mudharabah model has
been identified in this study and are being practised across the world especially Malaysia.
Each Takaful model has evolved in a more refined form as a result of certain issues
associated with the previous model. Question related issues arise in Takaful models as
Shari'ah Scholars belonging to different schools of thoughts have different point of views
on Shari'ah matters. Shari'ah issues are concerned with the independence, confidentiality,
competence, consistency and disclosure of responsibilities that affect functioning of SSB
in the organizations. Critics on the issue of profit sharing argue that it is illegal for
participants as well as for Takaful operators to share in profits due to tabarru nature
(donation) of contribution. Issue of underwriting surplus sharing prevents Takaful
operators to share the surplus amount and restricts their earning to Wakalah fee or their
share of profit. Issue of unearned Wakalah fee arises when a participant withdraws his
contract at the mid of Takaful period, as fee is usually charged in advance as upfront
charge when participant pays contribution amount. Therefore, it is considered to be the
most refined and acceptable model. Yet there is need to create consensus among
Shari'ah Scholars belonging to different schools of thoughts. A central Shari'ah Board
comprising of different Shari'ah Scholars representing their own fiqh is highly desirable as
it can resolve various issues that can create conflict of interest among different fiqhs
(Obaidillah, 2005). There is also need to counter corporate governance issues that raise
the concern for the accountability of company board of directors as they have been
criticized for maximizing the shareholders' profits while ignoring the rights of participants
(Sheila and Zahirin 2012). Shari'ah based corporate governance practices are considered
very much important for Islamic financial institutions including Takaful companies to create
transparency and fairness in their operations.
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