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1- What is the most important feature that distinguishes takaful from conventional insurance? (5 marks).* Your answer 2- Explain briefly the difference between a pure wakalh model and a pure mudarabah model in Islamic insurance. (5 marks).* Your answer 3- How the author consider the relationship between policyholders and TOs as a principal-agent model. (5 marks)* Your answer 4- What are the main conclusions of this paper? (5 marks) * Your answer Jermato com chaves Organisation 100(2015) 775-564 Contents lists available at ScienceDirect Journal of Economic Behavior & Organization Journal homepage: we viet.com/locato/iebie ELSEVIER Mark Optimal incentives for takaful (Islamic insurance) operators Hayat Khan Deportest of finance, ta Probeer School Sandy fusiness Economics and L. Le Trobe Chevenit deri Melbourne VIC 06. Australie ABSTRACT ARTICLE INYO Article story Recried tober 2014 A 2 Nov 2014 Available on 11 November 2014 ME 14 D The relationship between policyholders and an Islamic insurance Call operatoris in essence a principal-agent relationship. This paper analyzes the power of incentives offered to reful operators in mitigating problems associated with such a relationship. These incen tives include wokoch an upfront agency lee as a percentage of premiums: mudrabah, a share in investment income from technical reserves and surplus sharing a share in the insurance surplus). The paper concludes that all incentives offered to takaful operators must include surplus-sharing and that offering moderabah in the presence of surplus-sharing is optimal only when the risk adjusted return on investing technical reserves outweighs a similar return on effort exerted in underwriting risks. A wokoch hybrid is also recom mended as it induces the operator te increase the size of the pool that in turn, reduces average risk to the benefit of policyholders 2014 Elsevier BV All rights reserved Keywords Tokfiel Istamine Opincentives Wallah Mudron Agency theory 1. Introduction Islamic insurance (tokoful) is a relatively new but growing segment of the Islamic finance industry. As far as incentives are concerned, the most important feature that distinguishes takaful from conventional insurance relates to the nature of the contract that governs the relationship between the policyholders and an insurance company. Conventional insurance is primarily a contract of risk transfer as it transfers the risk of loss insured from the policyholders to an insurance company against an agreed amount of premium. The insurance company owns the premiums written and any surplus or deficit generated by the insurance operation Policyholders only have the right to claim under conditions identified in the insurance policy, Islamic insurance on the other hand isa contract of risk sharing among policyholders. The insurance company, referred to as the takaful operator (TO), merely manages affairs of the business against a variety of financial incentives. Premiums collected by Tos are therefore. in principle owned by the policyholders as a group and so is any surplus or deficit from the insurance operation. Participants in this case insure one another on a non-profit basis and make contributions to the takaful pool on the basis of tabarru' conditional and irrevocable donation) which is a non-commutative contract. TeL: 51393536 mailaddare Conventional and motor otherwise, larpodt hvements which includes interest and any payment and above the premium and gharar (uncertainty that resembles gambling the soft and sharer de tot apply to commutative contracts. Contribution to all post are therefore treated as are to get around the problem of ribe and stars. See 2000 and I camel (2006) Impex 10.06.2014 0167 2681/2014 Elsevier BV All rights reserved 195 HXhen/rumaleficentemic Whavior Organisation (2015):25-144 As is obvious, the relationship between the policyholders and a TO is that of a principal and an agent in the well-known agency problem where the agent (TO) may not work in the best interest of the principal (policyholders). In this context optimal contracting focusses on designing incentive schemes that induce the agent to work in the best interest of the principal (see Mas-Colell et al. 1995. Chapter 14). A related aspect is that since regulators have the responsibility and mandate to safeguard the best interests of the contracting parties, optimal incentives reduce the burden of surveillance on regulators. This paper analyses the incentive schemes offered to TOs primarily to understand the power of these incentives in mitigating the agency problem so that the interest of all parties (policyholders.operators and regulators) are served. This sort of analysis is viewed as a powerful tool and is frequently applied to real-world scenarios (see for example Basov and Bhatti, 2013: Banerjee et al. 2012: Shapiro, 2005: Bobchik and Fried. 2003: Laffont and Martimort. 2002; Eisenhardt, 1989 Cooper and Hayes, 1987) An additional significance of this exercise for the Islamic insurance industry in particular is that, in practice, the poli- cyholders do not have any direct or indirect input in the selection and design of these incentive schemes, which adds to the severity of the agency problem and shifts the responsibility to the regulators. Most regulators, however, do not have well-defined incentive-related guidelines, making them ill-equipped to deal with the agency problem and the analysis in this paper even more relevant. Much of the focus until now has been on regulatory issues common between conventional and Islamic insurance with little attention to the design of incentive schemes. This paper will hopefully assist regulators in understanding the role of incentives in the Islamic insurance industry and in reducing problems associated with the principal-agent relationship. The analysis in this paper corresponds to a scenario where policyholders, as a group, delegate regulators the right to design the incentive schemes on their behalf. The group of policyholders is therefore modelled as a single entity. The contribution of this paper is novel in the sense that it applies standard tools of optimal contracting to the operations of Islamic insurance, which to the best of our knowledge is the first attempt of its kind, and identifies the value addition of hybrid contracting when the agent's management role can be bifurcated into sub-tasks The rest of the paper is organised as follow. Section 2 starts with an introduction of alternative incentive schemes offered to TOs, followed by a parsimonious model of optimal contracting that analyses the impact of the alternative incentive schemes on a vector of efforts exerted by the operator (Section 3). These efforts mainly include (1) admitting policyholders into the takaful pool through (l) underwriting (selecting, classifying and pricing risks) and (1) investing a part of the premium pool (technical reserves) Section 3.2 derives optimal values of the incentives with a view to minimise the agency problem. This section also highlights the value added of individual incentive schemes and discusses the conditions under which hybrids of the alternative schemes are beneficial Section 4 concludes. 2. Incentives offered to takaful operators Financial incentives offered to Tos are restricted to be compliant with Islamic Law, referred to as shari'ah. In practice, these incentives are based on (i) an agency or wakalah contract where a TO manages fokaful operations against an upfront agency fee (1) a mudarabah (profit sharing) contract where the TO receives a share in investment income from technical reserves, and (ii) a modified muderabah (surplus-sharing) contract where the TO receives a share in insurance surplus. Most operators use a hybrid of these three incentive schemes in their operations. In a pure wakalah modela wakalah fee is generally expressed as a percentage of the premiumcollected from policyholders and is received upfront at the time a policyholder is admitted to the takaful pool. All claims and operational expenses in this case are paid from the takaful pool. The management of the takaful operation involves investment of the technical reserves and all profits or losses are credited to the takaful pool. In a pure muderabah model on the other hand, the TO's only compensation comes out of the profits from investment of the technical reserves. The modified muderabah contract is similar to the mudarabah contract but the insurance surplus (deficit) is now treated as mudarobah profit (loss). This modification implies that premiums, instead of technical reserves, serve as mudarabah capital, hence the name modified mudarabah contract Shari'ah compliance of the modified mudarbah model has been controversial (see for example Archer et al. 2009: Bakar, 2009). It is interesting to note that the modified mudarabah contract can be replaced with an arrangement where the underlying contract does not treat premiums as mudarubah capital, and where the share in surplus is treated as a reward for performance in a manner similar to a jualah or ialah (performance fee) contract. This means that shari'ah compliance may sometimes mean invoking the right shari'ah compliant contract that closely mimics a non-compliant one. The managerial function of a TO is not much different from that of a conventional insurance company. Like any con- ventional insurance company, a TO is expected to carefully underwrite risks in the process of admitting participants to the See ledjital (2004 for an application of the jualah contract in the mining industry. This points towards poor short compliance practices in the industry. It seems that a business perspective has been guiding the design of incentives more than a share a perspective, or that shari'ah experts have been reluctant to resort to more flexible alternatives visvis mudarabah and make (the two status quo contracts). See Gamal 2005 for a broader discussion on the incoherence of contract-based Islamic lancial jurisprudence horolofi hverr Orion 109 [20155-144 takaful pool, manage claims, and invest technical reserves. The difference lies in the underlying incentives to perform these functions. This is summarised in the following basic accounting identity of the insurance operation. P-COE+ITR where - Insurance surplus or deficit before operator's compensation: P-Net earned premium (net of reinsurance): COE-combined operating expenses: ITR-Investment income from technical reserves: CoE is the sum of underwriting expenses (UE) and net daim expenses-net of reinsurance claims (NCE). Eq. (1) summarises the best interest of the contracting parties. The best interest of the party with property rights to is best served by efforts that maximise . Assuming a reasonable level of competition in the market. this requires efforts towards (1) minimisation of the CoE and (11) maximisation of HTR. Since all surpluses or deficits belong to the insurance company, a conventional insurance operator puts maximum effort in all directions. A TO, on the other hand, works for policyholders against a variety of financial incentives. These incentives may or may not induce the TO to exert maximum effort due to the agency problem which motivates our analysis in this paper. Denoting the number of policyholders by which also represents the size of the takaful pool, and the premium charged to each policyholder by p.we can write Pnp Let W be the total compensation received by the operator as a result of an incentive scheme. In a wakalah model, the operator is paid a fixed proportion (a and mes motivates the operator to increase the size of the pie, but gives it no incentives to exert more than the minimum level of effort in underwriting risks or investing technical reserves. This is because underwriting effort and investment income from technical reserves do not increase its payoft. For the same reason, in a pure mudarabah model (m>0 and 5-0 the operator does not have any incentive to increase the size of the pie or exert greater than the minimum level of underwriting effort. In a pure surplus-sharing model (s>0 and cm-0), the operator has some incentives to exert greater than the minimum level of effort in all directions as her payoff in this case is increasing in the size of the pie, underwriting effort and investment income from technical reserves. The following highlights some important results in the context of hybnd contracts in is increasing in wakalah fee as ander- (1 - 5p>0. The effect is, however, reduced by the degree of surplus-sharing Intuitively, surplus-sharing crowds out the effect of wakala incentives because it allows the operator to recover part of the premium from the surplus and also because part of the premium is paid out in claims. In the absence of wakalah nesp- and anas-p-c>. Surplus-sharing therefore induces the agent to increase the number of policyhold- ers as it increases payoff of the operator. In general, anas= (1-ap-clc>0 only whena 0 6 Let us now state the main results. 1 All incentives offered to TOs must include surplus-sharing as s'>0 (as it motivates effort in all directions) it. A wakalah hybrid should be offered only when minimum effort is profitable (when average claim with minimum effort is less than the average premium, le, cp). This is when the operator always benefits from the increasing size of the pool. It also benefits the policyholders as an increase in the size of the pool reduces average risk of the policyholders. ii. A mudarabah hybrid should be offered only when the risk-adjusted return on investment outweighs the risk-adjusted return on effort exerted in underwriting. This is when a mudarobah hybrid increases the power of surplus-sharing incentives and induces the agent to exert greater effort. iv. In an environment or insurance category where return to underwriting is higher or when it is relatively less noisy. incentives should rely more on surplus-sharing and less on muderabah since Xw"/do?) 1+ (w2/03 am KU?/?)+(?/60) v. Eq. (28) indicates that the optimal size of the pool in wakalah-based models without surplus-sharing is greater than the optimal size of the pool in a surplus-sharing model without wakalah as s'0 when 7/07 +00) > 1/6 + 0) (see Appendix A for proof) v When the risk-adjusted return on investment increases, it is optimal to increase reliance on Mudarabal without reducing reliance on surplus-sharing when)-0 as im. KP/40) 1+(?/dar? -0 XP/007) 141 H.Khan Journal of Economie dhenier Organisation (2015) 135-14 However, when E(8, Fc) + 0, as "at}0 which implies substitution between the two when the risk-adjusted return on investment increases. Intuitively, this is because an increase in (f/607) reduces the impact of unexpected variations on investment income relative to their impact on underwriting effort. vit. Unexpected variations in claims reduce investment of technical reserves as they negatively correlate with investment income. This means the operator holds more reserves in its stock to finance any unexpected claims. To show this, we substitute Eq. (25) in 22) to get (29) Using the extended solution in Appendix A, we can show that F - ipas+- (30) R+07 A comparison of Eqs. 29) and (30) confirms our conjecture as " /do + 0)). This is similar to our base case model Risk in this case is however adjusted for the covariance effect. Furthermore, it is straightforward to show that the partial effects discussed in the base case have the same sign in the extended case (El) (A9) f( wo}X)-(0 is 200) (A10) 1(0* +007 XP +007)-(0) (00+ spook (111) P) (F+6q; }(u do? XP + do?)-(dows as Is +(1-3) (12) Kdo) (2.02X007)-( (1 m) dos s. (113) (+00' (1-53F+60) BP) am 1s+(1-5) is (A14) 200) (1 - XP + poft (1 - XP) 1 CO (1-5) (P.) (A15) CO - -- scount m. ame K001) (A16) (1-5) +00) (1 m) >O 2007) 144 + + H. Khan /Journal of Economic Behavior & Organization 109 (2015) 135-144 Appendix B. Solution of the base case model when the principal is risk-averse The agent's optimal choice of n, eu and I in this case is the same as in the base case model. The utility of a risk-averse principal can be written as Up = E(F) E(W) - 41(1 spo? +11- Is +(1s)m)l?o?! where y determines the principal's degree of risk aversion. Imposing the agent's participation constraint along with optimal choice of n. eu and I gives Up (p-C) 0 [sip zaman (1 - sap+s(p-c) --] 2. ) - skop + s'p CJP + su + [5+(1 smp slu? + 603) 31s +(1 s)mp(12 + $bo?) - 341 5)2 xo? - 211-1s +(1 s]m]lvo? The FOCs can be shown to imply the following solution -(-) (B1) (P/)-(2/40) (B2) 1 + (P/40?)+(1/6) (u/)+(1/6) (B3) 1 +(u2/004)+(V/6) Notice that similar to the base case model, m'> when i/o > 12/40. Moreover, the solution implies m + /a(22/40?)> 0, 0m+/a_u2/603) like the base case model. The principal's degree of risk aversion therefore does not change the qualitative results of the base case model. References d. M. S. + Akerlof GA. 1982. Labor contracts as partial gift exchange Q.J. Econ. 97 (4) 543-569. Archer, S. Karim, R.A., Nienhaus, V. 2009, Business models in takaful and regulatory implication, In: Archer, S. Karim, RA, Nienhaus, V. (Eds.). Takaful Islamic Insurance Concepts and Regulatory Issues, John Wiley and Sons (Asia), Singapore, pp. 9.30 Bakar, D.M. 2009, Shari'ah principles governing takaful models, In: Archer, S. Karim, RA. Nenhaus, V. (Eds.), Takaful Islamic Insurance Concepts and Regulatory Issues, John Wiley and Sons (Asia), Singapore, pp. 31-45. 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