The Islamic Financial Services Board’s Exposure Draft 18 contains key principles and standards of best practice for retakaful activities. Ms Susan Dingwall and Mr Martin Schneider of Norton Rose Fulbright LLP zero in on the distinct features of retakaful operations which have shaped the Draft, while summarising the Board’s guiding principles on retakaful.
In response to industry requests for a standard relating specifically to retakaful, the Islamic Financial Services Board (IFSB), on 5 November 2015, issued Exposure Draft 18 – Guiding Principles for Retakaful (IFSB-18). It contains key principles and standards of best practice for the retakaful activities of both takaful and retakaful operators and windows to be applied and enforced by industry regulators.
IFSB-18 is not intended to be a comprehensive set of standards, and the IFSB has reminded market participants that the standards in IFSB-10 (Shariah governance), IFSB-11 (solvency requirements) and IFSB-14 (risk management) also apply to retakaful activities.
As the core principles underpinning retakaful and the models commonly used by retakaful operators will already be familiar to the readers of this magazine (being the same as or largely similar to those applicable to takaful), this article focuses instead on providing a brief overview of some of the distinct features of retakaful operations which have shaped IFSB-18, the IFSB’s specific guiding principles on retakaful and examples of the recommended best practice associated with those principles.
Specific issues relevant to retakaful
The IFSB has identified a number of features of retakaful operations that differentiate them from takaful operations and therefore point to a need for distinct treatment, including:
• The nature of participants
In general, the participants in a retakaful arrangement will be sophisticated financial institutions, whereas the participants in a takaful arrangement will often be individuals or legal entities with only a limited understanding of the nature and operation of the takaful relationship and who therefore require enhanced protection from a regulator.
• International exposure
Retakaful operators tend to be more exposed to the international markets than takaful operators, either via their retrotakaful arrangements with overseas reinsurers or retakaful operators, or via their relationships with overseas cedants. This international dimension entails additional risk which a regulator must take into account.
• Nature of the risks underwritten
The retakaful market underwrites large and specialised risks, and in many cases provides a backstop to takaful undertakings that will not underwrite certain risks without the appropriate retakaful capacity in place. This necessitates a level of technical skill and experience which, in many cases, surpasses that of the takaful market.
• Capitalisation
The capital requirements relevant to a retakaful undertaking are likely to differ to some extent to those of a takaful undertaking, in view of the former’s particular risk profile. Losses, while they may occur less frequently, are likely to be of a larger size, meaning that depth of capital reserves is important.
• Shariah compliance
Retakaful operations have a heightened exposure to the risk of underwriting non-compliant business, due to the fact that they may not (and indeed it may be impossible for them to) assess the Shariah compliance of every ceded risk, particularly in treaty arrangements.
Guiding principles
The IFSB’s guiding principles are summarised below.
Governance
Principle 1.1
Retakaful operators must implement and maintain a comprehensive governance framework appropriate for the business model of their retakaful undertaking, which ensures the “independence and integrity of each organ of governance” and in which the mechanisms for proper control and management of conflicts of interests are clearly defined.
Such a framework should be designed to protect the interests of cedants as distinct from those of shareholders, and should include:
• the clear identification and segregation of strategic and operational roles and responsibilities of each organ of governance;
• mechanisms for monitoring and addressing the rights and interests of all stakeholders;
• the documentation of reporting lines and the accountability of each organ of governance;
• a legal and regulatory compliance function; and
• business continuity plans.
Principle 1.2
Retakaful operators must adopt, and ensure compliance with, an appropriate code of ethics and conduct.
Best practice recommendations include:
• regularly reviewing compliance with the code, and dealing with breaches in an appropriate manner;
• incentivising the reporting of potential breaches of the code, and providing protection for “whistle-blowers”;
• making the declaration of conflicts of interest mandatory and ensuring that decision-making is adjusted to account for the relevant conflict; and
• extending compliance with the code to the retakaful operator’s professional advisers and outsourced service providers.
Principle 1.3
Retakaful operators must aspire to the highest standards of truthfulness, honesty and fairness in all their statements and dealings, and must treat their customers fairly. While asymmetry of information between market participants is less of a concern in retakaful arrangements, retakaful operators are still expected to abide by such standards, not least because this is in keeping with Shariah principles.
The IFSB recommends that:
• material information is not withheld from cedants and that cedants themselves be subject to an obligation to disclose material matters;
• contractual documentation should, if possible, be finalised prior to inception and should be clear and unambiguous; and
• the retakaful operator should ensure that the relevant model and the treatment of the retakaful risk fund surplus are addressed in the contract.
Principle 1.4
Retakaful operators must exercise due care and diligence in all their operations, including the way in which they structure and offer their products and provide services, with particular regard to Shariah compliance and to the thoroughness of research and risk management.
The IFSB recommends that retakaful operators ensure that recruitment, training and incentive structures are designed to help ensure compliance with this principle.
Principle 1.5
Retakaful operators must ensure that they put in place the necessary systems and procedures and that their employees have the necessary knowledge and skills to comply with the principles in IFSB-18 and other relevant IFSB standards.
As a matter of best practice, the IFSB recommends that:
• all individuals with responsibility for carrying out operational or governance functions should be subject to “fit and proper” requirements; and
• all officers and representatives of, and any person performing outsourced services for, a retakaful operator should be provided with an appropriate level of technical and Shariah training.
Compliance with Shariah principles
Principle 2.1
Retakaful operators should ensure that all the business they undertake is compliant with Shariah principles, both contractually and in terms of the underlying risks accepted. They should have measures in place to identify and purify any tainted income. To meet this standard, the IFSB recommends that retakaful operators ensure that they have ready access to Shariah advisers who have received adequate training in retakaful. It is also recommended that the retakaful operator’s Shariah advisers should ensure that procedures for monitoring and assessing Shariah compliance are put in place and maintained.
Prudential framework
Principle 3.1
Retakaful operators must ensure that an adequate risk management framework with an appropriate scope (and compliant with IFSB-14) is in place and imbedded within an appropriate governance structure.
Principle 3.2
Retakaful operators must ensure that they have in place appropriate mechanisms to sustain the solvency of the retakaful undertakings they manage. Such mechanisms could include the use of a Qard facility to manage a retakaful risk fund’s solvency or liquidity risk. The IFSB makes specific recommendations to regulators on how to supervise the use of such a facility.
Principle 3.3
Retakaful operators must adopt and implement a sound investment strategy and prudently manage the assets and liabilities of the retakaful undertakings they manage. A fundamental aspect of a retakaful operator’s investment strategy is the assessment of investments for Shariah compliance. The IFSB recommends the implementation of a process which deals with this as part of an appropriate risk management framework.
Transparency and Disclosure
Principle 4.1
Retakaful operators must adopt and implement procedures for appropriate disclosures that provide market participants with fair access to material and relevant information. The IFSB expects retakaful operators to disclose information regarding their operations, in particular with regard to the retakaful undertaking’s financial strength and its compliance with Shariah principles, in order to allow its customers and their agents to form a view as to its position as a counterparty.
In addition, best practice includes disclosing to a potential cedant whether the retakaful operator intends to enter into retrotakaful or conventional retrocession arrangements, and the compliance of these arrangements with Shariah law.
Supervisory review of retakaful/ reinsurance arrangements
Principle 5.1
Supervisory bodies should monitor the retakaful or reinsurance programmes of takaful undertakings and the retrotakaful or retrocession programmes of retakaful undertakings, not only from a prudential standpoint but also with the aim of ensuring continued Shariah compliance. In doing so, they may rely on the takaful operator’s or retakaful operator’s Shariah advisers, as long as appropriate governance arrangements are in place to enable such advisers to discharge their responsibilities.
Step in the right direction
Given that the retakaful market is highly fragmented, not only across jurisdictions with different regulatory systems but also in terms of the implementation of Shariah principles, any attempt at harmonisation of standards across the industry is bound to be a challenging undertaking. While IFSB-18 cannot be overly prescriptive in the face of such fragmentation, it is a step in the right direction and will no doubt provoke discussion around the need to implement common, world-class standards in a market that must inspire confidence in its customers and participants if it is to continue growing.
IFSB-18 remains in a consultation phase, and will be finally submitted to the IFSB Council in April 2016.
Ms Susan Dingwall is a Partner and Mr Martin Schneider is an Associate with Norton Rose Fulbright LLP.