The sentiment in the takaful market has noticeably changed over the last 24 months. The focus has shifted from headlines about the rapid growth of the sector to instead concentrate on concerns about return on equity and the challenges arising from competition, lack of scale and access to talent. In the United Arab Emirates recent regulatory changes are likely to exacerbate these concerns in the short to medium term. But for the takaful operators who are capable of adapting there remain significant opportunities.
The Status of the Market
In its Annual Report (i) the UAE Insurance Authority reports that the insurance market in the UAE grew by 13.5% to a total written premium of US$9.128 billion. Regrettably, the report does not provide separate statistics for the takaful sector. However, figures published by Ernst & Young(ii) forecast the gross takaful contributions for 2014 of US$1.314 billion (approximately 14.3% of the total premiums). These statistics illustrate the comparative lack of scale of the takaful operators who comprise 11 of the 60 insurers licensed to operate in the UAE (or 18.3% of the total) especially taking into account the fact that a few of the larger takaful operators account for a disproportionate share of the premiums.
The regulatory landscape in the UAE is continuing to develop apace. Indeed, takaful operators have highlighted the need to keep up with evolving regulation as the second greatest risk to their business after competition in the market.(ii)
The Financial Regulations (iv) were published on 29 January 2015. These regulations are without doubt the most seismic change in regulation for the industry since the creation of the Insurance Authority in 2007.
The key feature of the Financial Regulations is that they create a fundamentally different prudential regime to that previously set out in the Insurance Law. The Minimum Capital Requirement (MCR) from the Insurance Law and Cabinet Resolution No. 43 of 2009 has been retained, requiring a fixed MCR of AED100 million for insurers and AED250 million for reinsurers. This is now supplemented by two additional capital requirements:
- the Minimum Guarantee Fund (MGF) which comprises an amount which is the higher of: (i) not less than one third of the Solvency Capital Requirement; or (ii) the higher of a minimum amount to be specified by the Authority for each type of business and a specified percentage of the net earned premium for each type of business; and
- the Solvency Capital Requirement (SCR) being a risk-based capital calculation that utilises the solvency template published by the Authority. The SCR introduces, for the first time in the UAE, a risk-based capital component for insurers.
Takaful operators are required to maintain the higher of the MCR, the MGF and the SCR. In practice, it is likely that the MCR will remain the key requirement for much of the takaful industry given the relative youth and lack of scale of the players.
The imposition of limitations on the type of assets into which an takaful operator may invest, are the aspect of the Financial Regulations that have received the most comment in the media to date. The Financial Regulations require assets to be diversified and adequately spread and therefore include restrictions on the types of assets which may be used for investment purposes and also incorporate limitations on the percentage of each type of asset that may be held with a single counterparty in order to address concentration risk. Thus, for example, investments in real estate are restricted to 30% of an takaful operator's total portfolio and investments in UAE equities is limited to 30% of the portfolio and not more than 10% of the portfolio may be held in a single issuer. Importantly, takaful operators may not hold more than 50% of total invested assets outside of the UAE and 100% of technical provisions must be held in assets within the UAE. With an eye on the difficulties that befell the AIG Group during the financial crisis, the Financial Regulations prohibit the use of derivatives except for hedging purposes.
The investment restrictions will come into effect on 29 January 2017; albeit, the limitation on real estate will only be effective from 29 January 2018. These changes are likely to require a number of takaful operators to adjust their investment holdings. For those facing challenges in meeting the requirements (for example, because of being overweight in real estate), it would be sensible to start the process of liaison with the Insurance Authority early, especially if exemptions are going to need to be required.
Whilst the solvency requirements and investment restrictions have obtained the most attention in the media, it is those aspects of the financial regulations impacting on the systems and controls, corporate governance and record keeping of a takaful operator which will have the most significant impact.
Compliance with the Financial Regulations will require many insurers to establish new internal governance structures, including the creation of two new Board of Director level committees: an Investment Committee and an Audit Committee.
In line with the focus on international regulators on the role of key individuals within financial services organisations, the Financial Regulations also impose significant requirements on the Board of Directors (and, in particular, the Chairman of the Board) and senior management to understand the risks to which insurers are exposed and to develop and implement appropriate systems and controls to manage such risks. There are also detailed requirements as to the role and obligation of the Actuary, Investment Committee, the Internal Audit Department, the External Auditor and, to a lesser degree, the Compliance Officer.
There are detailed obligations imposed in relation to all of the key individuals. In addition, the list of policies and procedures and reports to be submitted to the Insurance Authority is extensive. The cost of implementing these requirements may have a disproportionate effect on takaful operators. Whilst the Insurance Authority has been quick to point out that each company must establish systems and controls and adopt governance models appropriate to the needs of their business, it is (in many cases) the smaller companies which have the least capacity in these areas and will likely incur the greatest costs in implementing them.
In addition to the Financial Regulations, Cabinet Resolution No. 28 of 2015 has recently extended the time period for composite insurers to comply with the requirements of Article 25(2) of UAE Federal Law 6 of 2007 until August 2016. This provided that an insurer in the UAE "may not conduct life assurance and fund accumulations operations and liability insurance operations at the same time." For takaful operators with composite licences the cost of segregating the family takaful business and transferring it to a new listed public joint stock company is unlikely in many cases to be acceptable. Therefore, they may find that their product range is curtailed.
Adapting to the New Reality
The intention of the new regulations is clear: the Insurance Authority wish to ensure that the industry is financially strong and that insurers have a clear vision of the risks to which their businesses are exposed. The cost of implementing the requirements of the Financial Regulation may also be perceived as intended to encourage consolidation thereby removing the smaller players from the market. However, such transactions are not without their challenges and we have seen fairly limited M&A activity to date.
To date a number of leading international players have been unable to establish operations in the UAE due to the moratorium. The requirement to segregate the life (family takaful) business from the general business of composite insurers may therefore also encourage joint ventures with international life insurers seeking to enter the UAE market.
For those players who do not wish to consolidate or sell part of their equity to foreign insurers, there remains the option to establish pooling arrangements with other takaful operators across the region. Such pooling arrangements would be potentially beneficial by allowing the operators to share resources, diversify the risks to which they are exposed (through the internal reinsurance of the business written by each member) and benefit from the technical expertise of the other pool members.
It is clear that there will be opportunities arising from the regulatory changes. For those prepared to adapt to them at least.