Risk management is of vital importance in islam and takaful

pretend steering is of snappy splendour in islam and takafulABSTRACT lay on the line management is of vital importance in Islam and Takaful provides a way to manage hazards in production line according to Sharah principles. This look into paper attempts to identify various types of fortunes involved in Takaful business that affect practicable and coronation functions of Takaful doers across the globe and finds the ways to manage those happens effectively. However, takaful movers often face difficulty in managing securities industry and attribute happens as Sharah manageable character of Takaful pay off does not allow Takaful companies to deal with sake outrank and monetary derivatives that collapse been unanimously considered contradictory to Sharah by Muslim jurists. This research identifies Islamic financial instruments like cooperative hedgerow and bi-lateral mutual adjustment that aim at providing mutual gains to some(prenominal) parties by the way of fo rtune sharing and keep be use as an alternative to unoriginal derivatives. The research paper attempts to provide a framework to enhance risk management culture among Takaful operators. It too discusses the challenges that need to be encountered to enhance risk management practices among Takaful operators. INTRODUCTIONMany Muslims misunderstand the concept of fate. For some Muslims believe that the future(a) is in the hand of Allah, where they argon facing with fatalistic mentality by putting themselves in the doctrine, whether one is rich or poor, happy or sad, it is fated by Allah. It is a well-behaved dealing with luck. In fact, efforts and prayers should precede this kind of belief (Iqtisad Al-islamy, 2003). For a long time, same misconceptions have been associated with insurance. Muslim scholars and Islamic jurists have treated insurance immoral, haram and repugnant to Sharahwithout providing an alternative solution to Muslim Ummah. As a outgrowth of these prevalent misc onceptions, any effort or risk management strategy to insure the assets or emotional state has been considered against the fate and will of Allah. In Islamic financial planning, Takaful is a way to reduce the financial risk of loss collectable to accident and misfortunes (Iqtisad Al-islamy, 2003). As a matter of fact, Takaful plan is an alternative to the insurance in the ceremonious financial planning. In Takaful plan, the participant would pay particular amount of money as contribution (known as the premium) partly to risk fund (the participants special account) using the concept of tabbaru (donation) and partly to another party (known as Takaful familiarity) with a mutual commensurateness that, the kafiil (Takaful company) is under a legal responsibility to provide for the participant a financial protection against unexpected loss, should it happen within the agreed period. The focus of this research paper is to identify various types of risks associated with Takaful busine ss and devise criteria for managing risks and enhancing risk management culture among Takaful companies. It also discusses challenges to risk management in Takaful.RISK focussing Risk is the chance of happening of something that will have an impact upon our objectives. It is measured in cost of likelihood and consequences (GOWA, 2002). Traditionally, concept of risk has been associated with uncertainty of events in future. Higher the uncertainty of events, higher is the risk. In insurance, risk is the amount of loss associated with property or life. Risk to property spate be a loss or damage to car, building, house, etc. Risk to life can be described as poor health, premature death, bodily injuries as a result of accident etc. (Rejda, 2006 p.23).Risk management is a process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating much(prenominal) exposures(Rejda, 2006 p. 63). According to New Zealand standard of Risk ov ersight, It is the culture, processes and structures that ar directed towards the effective management of potential opportunities and ad indite effects. In fact, risk management is an ongoing process that encompasses all aspects of our life.RISK MANAGEMENT UNDER SHARIAHRisk traditionally means possibility of contacting danger or suffering, harm or loss (Iqtisad Al-islamy, 2003). Risk is an element of life in this world for being ignorant of the future. It is also factor of investing that one should take time to understand prior to selecting any specific enthronization instruments or any new adventures. Muslims are asked to work hard in order to be able to interpolate their conditions as obvious in the verse of Holy ledger, Verily never will Allah change the condition of a people until they change it themselves (with their own souls) (Quran 311). However, it is true that only Allah knows ones future and fate, Muslims should extend to achieve the goodness in this world and the hereafter. Submission to Allah, of course, has a positive effect on human port. For it will lead to peace and contentment. Undoubtedly, one has to salute every single thing to Allah, but it supposes to be after his hands stretch out to do the best effort as he can, to change himself, so that he would be able to manage and to cope with unforeseen calamities or misfortune.Prophet Muhammad peace be upon him once asked a Bedouin who had left his camel untied, wherefore do not tie your camel? the Bedouin answered, I put my pull in Allah the prophet then said, tie up your camel rootage then put your bank in Allah( Sunan al -Tirmizi, vol.4, No. 2517, p. 668). This conversation depicts not only how should Muslims accept their fate but it also indicates how do Muslims reduce the risk of loss and calamities.Quran has presented stories of the previous prophets so that Muslims can take the lessons from their experiences. The story of the prophet Joseph, for instance, tells us about finan cial planning. The story of Prophet Yaqub, Josephs father, tells us about the management of risks as Yaqub commanded his sons to enter Egypt from different gates. Quran states, Further he said O my sons Enter not all by one gate enter ye by different gates. Not that I can profit you aught against Allah (with my advice) None can command except Allah On Him do I put my trust and let all that trust put their trust on Him (Quran 1267).The history of the prophets migration to Madinah gives us other lessons on how the Prophet (SAW) managed the risk. The Prophet reduced the risk of getting killed by asking Hazrat Ali (R.A.) to sleep in his bed during the night of emigration. It was reported that as night advanced, the Quraish posted assassins around the Prophets house. Thus they kept sentry all night long, waiting to kill him the moment he left his house early in the morning, peeping now and then through a good deal in the door to make sure that he was still lying in his bed.All these ab ove examples depict that risk management is in the grow of Islam. We, as a Muslims, should put our trust onto Allah only after meticulous planning and best utilization of all the available resources. NORMS OF ETHICS Obaidullah (2002, pp.2-4) has identify norms of strength and ethics for Sharahbased risk management in a business contract. These norms are also applicable to Takaful contract and are briefly described as adhere Each party in Takaful contract should be free to accept the terms and conditions of the contract and no coercion is imposed on any party. Takaful contract should be free from element of riba ( worry) that is prohibited by Shariah. One of the major objections on the contract of conventional insurance by Sharahscholars is element of riba in its investments for which it is considered illegal and unIslamic. There should be no uncertainty or ambiguity about the nature of contract. Excessive uncertainty is not permissible in Shariah. For example, Sharahscholars dis allow conventional insurance contract where no party clearly knows how and from where the insured amount is to going to be paid in case a loss or mischance occurs to the insured. There should not be any element of gambling in Takaful contract. It means that Takaful contract should not be aimed at getting a huge advantage at the cost of others. Rather, participants should have sincere intention of attend toing each other in case of loss or catastrophe from a phrase fund. Contribution amount for participants should be adequate and fair and should be determined by actuaries and approved by Sharahscholars. Takaful customers (participants) should have equal nark to adequate, accurate and timely market information related to Takaful products and companys performance where they want to contribute their money. Rights of any third party should not be adversely touch on by Takaful contract between deuce parties. It means Takafulcontract should not be detrimental to any third party. Th ere should be unrestricted public interest in Takaful products and its business contract which should work for the gain ground of people at elephantine.TYPES OF RISKS IN TAKFUL BUSINESSBusiness industry is prone to a number of risks. louvre types of risks in business (Basel, 2006 IAIS, 2004) have been identified that are relevant to Takaful business. First two types of risks (underwriting and operational risks) are directly related to operations of Takaful company season remaining three ( reference book, liquidity and market risks) are associated with the investment activities of the company. i. Underwriting RiskUnderwriting risk is pertinent to insurance and Takaful. It occurs due to adverse selection of applicants or due to re-Takaful risk as a result of inability of re-Takaful operator to meet the obligation towards ceded company under re-Takaful agreement (IAIS, 2003 pp.32-33). Adverse selection refers to the tendency of selecting applicants that result in higher than averag e chance of loss (Rejda, 2006 p. 45). The risk of adverse selection arises when applicants with higher than average chance of loss succeed in obtaining Takaful insurance coverage at standard rates e.g. high risk drivers or persons with skilful health problems. It results in higher claim ratio and put the firm on high liquidity constraints. Re-Takaful risk occurs as the ceded company remains liable for a mete out of outstanding claim to the extent re-Takaful operator fails to provide financial protection to Takaful operator in accordance with agreed terms. Both adverse selection and re-Takaful risk hamper the firms underwriting capacity disturb the change turn tail form and hence affect the stability of the profits of the company.ii. Operational RiskOperational risk is not a well defined concept , yet Basel embrace (2006, p.144) defines it as a loss that occurs as a result of inadequate or failed internal processes, people, technology or from external events.Internal processes mishap occurs (Ahmed Khan, 2001 pp.29-30) as a result of inaccurate processing of transactions, inefficient record keeping, violating operational confine limits, non-compliance of regulations etc. people risk may occur due to incompetency of employees, fraud and failure to perform the duties. Technology risk may arise as a result of telecommunication system or electronic computer net profit breakdown. Risks from external events allow unenforceability of regulatory policies, legislation and regulations that affect the fulfillment of contracts and transactions in the organizations. These risks are also called legal risks and are considered a part of operational risks.iii. Credit RiskCredit risk occurs a result of default of counterparty when it fails to meet its obligations in time and in accordance with agreed terms (IAIS, 2004 p.14).In case of insurance, ascribe risk may be treated as default risk, migration risk, spread risk or concentration risk. Default risk occurs when Takaful operator does not receive or partially receive cash flows or assets to which it is entitled because the other party fails to meet the obligations of the contract. Migration risk occurs when probability of a future default of an obligator adversely affect the contract today. Spread risk occurs due to market perception of increased risk on either macro or micro basis. Concentration risk is the result of increased exposure to losses due to concentration of investments in a particular geographical area or economic or industrial sector. Takaful industry is also exposed to these risks. iv. Liquidity RiskLiquidity risk is the risk resulting from Takaful companys inability to meet its obligations (i.e. claims payments and maturity toll of policy) when they fall due. This risk occurs because the company has insufficient liquid assets or high level of liabilities (IAIS, 2004 p.18). Liquidity risk includes liquidation risk, affiliation investment risk and capital funding risk.Liquida tion value risk is the risk under circumstance when assets are liquidated below their real (market) value. Affiliated investment risk is the risk that investment in an affiliated or member company might result in drain of financial or operating resources. Capital fund risk is the risk that insurance company will not be able to outsource funds in case of large claims. Takaful industry, just like conventional insurance company, faces similar types of liquidity risks. v. Market RiskMarket risk is the volatility of prices in instruments and assets of Takaful company in the market. It can be classified as equity price risk, interest rate risk, currency risk and commodity price risk (IAIS, 2004, p.12). Equity price risk is the risk of loss resulting from changes in market price of equities or other assets. Interest rate risk is the risk of loss resulting from changes in interest rates that adversely affect the cash flows of the insurance company. Currency risk is the risk of loss resulti ng from volatility of exchange rates that adversely affect the operations of insurance company. For a Takaful company, it does not include interest rate risk, however Takaful operators are exposed to mark up price risk as avoidance of interest based transactions is classifiable feature of Sharahcompliance.MANAGING RISKSAll types of risks in Takaful require specific risk management strategy and need to be managed on individual basis.i. Underwriting Risk ManagementUnderwriting risk can be managed by establishing standard selection procedure consistent with the companys objectives. Most of the Takaful operators require physical inspection or medical reports of the applicants that have serious health problems or prone to higher than average risk. Some have introduced computerized underwriting system to standardized underwriting procedure and minimizing the chance of adverse selection. For example, Takaful Ikhlas Sdn. Bhd. of Malaysia uses computerized underwriting procedure for motor Ta kaful where applicants who meet standard requirements are automatically selected for Takaful. Others are rejected or alternatively are offered higher contribution rates for the extra risk. To minimize re-Takaful risk, Takaful operator can respect the financial strength of re-Takaful operators in the region and diversify the risk geographically by making arrangements with more than one re-Takaful operator. ii. Operational Risk ManagementManagement of this risk is more complex as it arises from failure of internal processes, people, information system breakdown and non-compliance with regulatory standards (Ahmed Khan, 2001 pp. 38-39). Senior management and board of directors of Takaful company should devise policies and develop strategies to manage and reduce operational risks. Sources of operational risk (i.e. people, processes and technology) should be handled carefully. This raises the importance of somatic governing body culture in the organization. Given the newness of Takaf ul industry, computer packet available for conventional insurance might not be appropriate for Takaful industry. This calls for recruiting talented professionals in the field of informational technology so that they could develop software to meet peculiar needs of Takaful industry. Independent external auditors can also play an important role in mitigating operational risk as they insinuate out disfigures in internal processes of the organization. This calls for proper disclosure of activities and autarkical and secure reporting system. iii. Credit Risk ManagementUnder conventional insurance system, credit exposure limits are established within companys investment policies to mitigate and manage default risk, migration risk, spread risk and concentration risk as discussed under credit risk. Usually, following credit exposure limits can be established for insurance company investment and credit activities (IAIS, 2004 pp.16-18). Internal and external rating of counterparties Limit on maturity of credit facility (prefer short term credit over long term credit) Limit on maximum investment amount or a certain percentage of investment exposure to a single issuer, industry, geographical region or some other risk classification.Prohibition of interest does not allow Takaful companies to investment in interest-based instruments (Chapra and Khan, 2000). Moreover, Takaful companies do not have access to credit derivatives that are considered effective instruments for credit risk mitigation. Yet Al-Suwailem (2006 pp.67-68) argues that futures and plectron contracts result in losses for more than 70% of the time and hence such instruments are considered as factors of loss, not of gain. The non-availability of Islamic derivatives raises the importance of internal control mechanism for Takaful operators which ensures that credit risk exposures are maintained within limits of prudential standards defined by internal controls.iv. Liquidity Risk ManagementIAIS Report (2004 , p.20) identifies two approaches in order to hedge liquidity risk that are also applicable to Takaful industry. These are interchange flow modeling Liquidity ratiosCash flow modeling is done in order to assess the amount of deficit, surpluses or liquidation value risk in order to meet the needs of Takaful industry. Takaful operator should make sure that it has sufficient liquid assets in order to meet liquidity risk and unexpected liquidity requirements.Use of liquidity ratios will help Takaful operator to set the amount of liquid assets required to meet demands of liability portfolio, desired level of liquidity ratio will also help in determining Takaful operators investment policies.Capital funding risk could be mitigated by setting contingency plans and drawing cash from re-Takaful policies. This form of liquidity hedging could be recognized by knowing current level of liquid assets in hand to meet Takaful operators investment policies. In order to identify and evaluate liquid ity risks, Ahmed and Khan (2001, p.38) emphasize the need of adequate internal control and proper disclosure of information in the organization. Towards this end, it is essential to have regular independent reports and internal audit function should periodically review the liquidity risk management process.v. Market Risk ManagementIn conventional insurance, management of market risk includes devising strategies to manage interest rate risk, exchange rate, and commodity price risk as well as equity price fluctuations. Takaful operators are not involved in interest based transactions so they do not face this risk. However, KIBOR (Karachi Inter Bank Offered Rate) can be used as bench mark for markup in Islamic financial institutions in their financing activities.Conventional institutions manage the market risk using financial derivatives such as futures, forward, option or swap contracts (Chapra Khan, 2000 p.55). Takaful operators face difficulty in managing market risk as these finan cial derivatives are not compatible with Sharahin the eyeball of Islamic scholars. However, according to Al-Suwailem (2006 pp.118-126), cooperative hedging and bi-lateral mutual adjustment are acceptable instruments under Sharahto mitigate currency risk and interest rate risk respectively. Additionally, Takaful operators could apply stress tests and valuate at Risk (VaR) techniques to mitigate commodity price risk and equity risk. Stress testing is one of the risk management tools that can be employed to assess the vulnerability of portfolios to abnormal shocks and market conditions. Value at Risk is the probability of portfolio losses exceeding some qualify proportion.ENHANCING RISK MANAGEMENT CULTURE Cultivation of risk management culture is extremely important to form a robust and resilient Takaful industry in Pakistan. This objective, however, could not be achieved without active participation and collaboration of regulatory regimen, senior management of Takaful companies an d members of SharahSupervisory Board (SSB). Towards this end, regularities authorities should make sure that stress testing and Value at Risk (VaR) reports as identified above are regularly produced and obtained from senior management of Takaful operators in addition to reports of Takaful risks. Regular review of these reports will greatly facilitate the regulatory authorities as well as Takaful operators to enhance risk management practices in Takaful industry.Moreover, effective implementation of internal control and corporate political science system could prove to be of vital importance to Takaful operator as well as to concerned regulatory authority. It will help the authorities in effective monitoring of Takaful activities and managing different types of risks hence enhancing the functioning of Takaful operators in the industry.Figure 1 shows the steps for effectively manage the risks in Takaful business. In the first step, possible risks in the way of Takaful business are id entified. In the second step, strategies are developed to cope with and manage the risks effectively. In the third step, process of recognition and strategy formulation and implementation related to each type of risk is examined through review reports and effective measures are taken to counter any flaw or discrepancy in the previous process.CHALLENGES TO RISK MANAGEMENT In spite of effective risk management techniques discussed above, there are certain challenges in the way of risk management for Takaful.i. Internal ControlsInternal controls are indispensable for recognizing and assessing risks faced by financial institutions including Takaful companies. Basel Committee (2005) and IAIS (2006a) reports have focused on the importance of internal controls for banking institutions as well as for conventional insurance companies respectively. Chapra and Ahmad (2002) found that existence of effective internal control have prevented the financial institutions from systemic crisis and ena bled them to have early detection of problems and associated risks they might face in future. These experiences highlight the importance and need of internal controls for Takaful companies. Unique nature of these companies from conventional insurance demands the fulfillment of Sharahaspects. IFSB and IAIS joint operative group (2006) maintains that to have effective internal control mechanism, Takaful companies must ensure Sharahcontrols in addition to all statutory regulations. It urges the need of a regularSharahaudit as a part of an on-going internal control system.ii. Corporate GovernanceThe corporate plaque structure specifies the distribution of rights and responsibilities of the Board, manager, shareholders and other stakeholders (OECD Report, 1999) yet effective corporate governance ensures the independence of board of directors (BOD) who in turn devise polices and implement strategies for risk management and hold the management accountable to shareholders (Psaros and Seam er, 2002 p.7). Lack of an effective corporate governance framework hampers the independence of board of directors (BOD) and hence poses a challenge to risk management. It in turn increases the operational risk which might result in failure of operations due to inability of BOD to implement unbiased and independent decisions for the best interest of all stakeholders. Takaful companies are confronted with an additional challenge related to corporate governance of SharahSupervisory Board (SSB). Grais and Pellegrini (2006b) identify corporate governance issues that affect their role and functioning in the organizations. It calls for a greater need to incorporate corporate governance culture to overcome related issues of Takaful industry. iii. SharahBased ChallengesAccording to Ahmed Khan (2001), most of the risk management techniques are not applicable to Islamic financial institutions due to the requirements of Sharahcompliance. It creates Sharahbased challenges to risk management for Takafulcompanies as well. These challenges arise as Sharahrestricts the use certain instruments that are considered useful in conventional risk management e.g. derivatives (futures, options, swaps etc.) and sale of debts. Al-Suwailem (2006, pp.89-90) argues that Sharahconstraints to human behavior do not strangle creativity, rather these constraints are the major driving force behind the creation of innovative financial instruments. He suggests several Islamic financial instruments for risk management and concludes that Sharahis abundant with real solutions to the present problems of gambling and speculation. It provides directions to Sharahscholars and experts of Islamic finance to explore the dimensions of Sharahin order to integrate risk management practices with value creation.iv. Financial EngineeringFinancial engineering aims at designing new and innovative Sharahcompliant Islamic financial instruments for IFIs including Takaful companies. Chapra and Ahmad (2002) maintain th at financial engineering has emerged as the greatest challenge faced by Sharahscholars of present time as it poses major threat to IFIs to become competitive in the contemporary business environment. Process of natural endowment fatwas by Sharahscholars regarding the permissibility of a financial instrument is quite slow and over-conservative (Iqbal et al, 1998 pp.47-48) as Sharahscholars and experts of modern finance have different academic backgrounds. They use technical terms related to their own field that are most of the time not easily understandable to other party. The need is to produce scholars with Sharahbackground that also have working knowledge of modern finance to meet the acute challenge of financial engineering. v. Islamic Financial MarketIslamic financial market provides a secondary market for trading of Islamic financial instruments. In the absence of this market, it will be extremely difficult for Takafulcompanies to maintain its liquidity position to make act claim payments when they become due. Retaining a large portion of Takaful fund to maintain high liquidity ratio will affect the efficiency of the firm and its scrap as compared to conventional insurance companies that have ready access to liquid bonds and t-bills. Islamic Financial Market will greatly facilitate the Takafulcompanies to invest large portion of their fund in Islamic financial instruments and increasing their efficiency and competitiveness while maintaining low liquidity ratio. It will also help Takaful companies in hedging market risk by providing alternative instruments to financial derivatives that are not acceptable under Shariah.vi. Need of Private Credit Rating AgenciesAlthough external Islamic Rating Agency (IIRA) has been set up in Bahrain to judge the Sharahcompliance and financial strength of Islamic financial institutions (IFIs) including Takaful companies, it is not be possible for IIRA to rate thousands of counterparties with whomTakaful companies deal. C onsequently, it calls for the need of private credit rating agencies in each Muslim country that could provide information related to financial strengthen, fiduciary risk and credit worthiness of thousands of counterparties that privately issue financial instruments (Chapra Ahmed, 2002 pp.80-81). This information could provide great help to IIRA in rating these companies and make it readily available to Takaful companies and other raise parties. CONCLUSION AND RECOMMENDATIONSRisk management is of vital importance in Islam and Takaful provides a way to manage risks in business according to Sharahprinciples. Five types of risks have been identified in Takaful business that affect operational and investment functions of Takaful operator. Operational risk can be managed by enhancing corporate governance culture in the organizations. Cash flow modeling and use of liquidity ratios is quite helpful to identify liquidity constraints. Takaful operators might face difficulty in managing mar ket and credit risks asSharahcompliant nature of Takaful contract does not allow Takaful companies to deal with interest rate and financial derivatives due to their speculative nature by which they tend to benefit one party at the loss of other. On the other hand, Islamic financial instruments like cooperative hedging and bi-lateral mutual adjustment aim at providing mutual gains to both parties by the way of risk sharing. Risks associated to Takaful have raised several challenges that need to be encountered to enhance risk management practices. Regular Sharahaudit is found to be an built-in part of effective internal controls that prevent the companies from systemic crisis. Corporate governance calls for independence of BOD to devise policies for effective risk management, make unbiased decisions and propose issues related to functioning of SSB. Sharahbased challenges call for devising innovative Islamic financial instruments as Sharahis abundant with real solutions to present bu siness dilemma and does not hinder creativity. Exploring those solutions will help to meet the challenge of financial engineering. Islamic financial market will greatly facilitate the task of Takaful companies to invest large portion of their fund in Islamic financial instruments and increase their efficiency and competitiveness. There is need to establish private credit rating agencies that could assist IIRA to rate thousands of counterparties for the benefit of Takaful operators.