Given the wealth created by the oil boom in the Middle East, Islamic finance has become an increasingly important business sector (a topic explored further in ‘The Big Draw’, Middle East Economic Digest (MEED) 30 March – 5 April 2007). In particular, attention has focused on the traditional concept of Islamic insurance (‘takaful’), and the issue of Islamic-compliant bonds known as ‘sukuks’.

Islamic finance

Some people are sceptical about Islamic finance because of the need for compliance with stringent principles deriving from Shariat (Islamic) law.

Shariat principles forbid unacceptable elements of risk and uncertainty often found in conventional insurance. The Shariat requirements – to make ethically sound investments and to abstain from receiving interest – are fairly daunting (a subject examined in greater detail in ‘Takaful Must Build on its Ethical Appeal to Expand’, Insurance Day, 12 April 2007). However, with more than 25% of the world’s population professing to be practising Muslims, and ratings agencies such as Standard & Poor estimating growth rates of 40% a year in the takaful markets, the subject of Islamic finance (and takaful in particular) merits the attention of London’s financial professionals.

Takaful

Generally speaking, takaful is a profit-sharing business venture between the insurer (usually referred to as a ‘takaful operator’) and its policyholders (‘participants’). In essence, as with mutual insurance, the policyholders effectively choose to guarantee each other, subject to solvency. There is solidarity among the participants, who agree to contribute to a common fund with an understanding of ultimate self-benefit if certain specified contingencies occur.

The similarity with conventional insurance ends there because, in the case of takaful, the insurer is only permitted to invest the premium pool in Shariat-compliant products (see further ‘Takaful Take-up Rises as Insurers Increase Range’, Insurance Day, 16 June 2006). This makes it difficult – although not impossible – to comply with financial regulations (such as those created by the FSA) regarding the diversification of investments.

A takaful operating company generates its funds through the contribution of seed capital from founding shareholders. This money covers start-up costs and initial investments. Additional funding may be raised through donations by further participants to the operating company’s takaful fund. The founding shareholders appoint a Shariat advisory board, whose main purpose is to ensure that the company’s actions are Shariat-compliant.

There are various models of takaful operators that address the part played by the company in relation to its participants. The differences usually relate to the role of the company as agent or partner – a distinction which determines whether the takaful operator is entitled to any profits in addition to its fees (see further the ‘Takaful Take-up Rises as Insurers Increase Range’ article cited earlier).

Retakaful

The number of Islamic-compliant reinsurers (known as retakaful operators) continues to grow. Currently, Middle Eastern retakaful operators benefit significantly from local regulations that require a fixed percentage of ceded lines to be placed with local retakaful entities.

However, takaful operators sometimes look to reinsure further risks with reinsurers that do not necessarily make ethical investments with their premium pools. This arrangement does not appear Shariat-compliant and may lead to a conflict with the Shariat advisory board.

London’s strong position

London is in a very strong position to benefit from the growth in Islamic financing because of its long-established reputation as a well regulated financial centre and because it possesses the professional skills required to arrange and structure Islamic products effectively. By contrast, inherent risks and divisions have weakened other players – especially, Dubai and Qatar – as competitors (see further ‘The Big Draw’ article cited earlier). Despite the Dow Jones Islamic market index, which tracks companies that meet the generally accepted criteria for Shariatcompliant investments, the US is not best placed to become a major player in the Islamic finance arena. This is partly because of a perceived hostility towards Islamic funds and partly due to the stringent corporate governance requirements imposed by the Sarbanes-Oxley Act.

As for London, in 2001, the global index group FTSE initiated a ‘green’ index called FTSE4Good. Dubbed ‘FTSEfeelgood’ within the industry, it tracks companies that meet ethical standards as set by the Ethical Investment Research Service. A fair number of companies that appear in the index ought to meet the requirements of any Shariat advisory board.

Proposals in the finance bill covering alternative finance investment bonds also strengthen London’s position with respect to Islamic finance and, in particular, takaful. March’s pre-Budget announcement allows for profit payments (interest) under alternative finance investment bonds – such as sukuks – to be tax deductible and so it will no longer be a constructive tax penalty to release profits under a sukuk in the UK (see the finance bill 2007, Part 3 (income, corporate and capital gains tax), clause 52). However, while England will be the first western nation to issue sukuks – which are said to offer competitive returns and have a secular ethical appeal – other non- Middle Eastern countries such as Malaysia and Pakistan do have a long-standing reputation for dealing with this type of financial instrument. Some international insurance companies and reinsurers have already tried to enter the takaful market in the Middle East, with varying degrees of success. It is, however, difficult to obtain the requisite authorisations, so ratings agencies recommend that global players wishing to follow suit first establish relationships with the local players and then build on technical partnerships. (For more on this topic, see ‘Unicorn launches takaful brand’, MEED 27 April – 3 May 2007.)

Currently, there are UK takaful operators who do not appear to be specifically regulated. This is going to change. The non-life subsidiary of British Islamic Insurance Holdings (BIIH) has recently submitted a formal application and business plan to the FSA.

The way forward

Ultimately, success in the Islamic finance market vis-à-vis takaful will depend on two factors: 

  • understanding the intricacies of Islamic finance against the background of Shariat law; and 
  • the existence of a stable and regulated centre to this new market. Given both these things, London stands an excellent chance of becoming a world centre for Islamic finance and building a strong bridge with the Muslim community.