Abstract
The takaful industry is searching for an optimal model for Islamic insurance operation, which has turned out to be a challenging task. This paper translates the abstract scientific knowledge accumulated in the optimal contracting literature into a simple, nontechnical, analytical framework to analyze alternative business models which could be used by regulators to align the best interest of shareholders and policyholders in the takaful industry. This paper shows that the wakalah–surplus-sharing hybrid serves as the optimal structure for takaful operation; in the presence of Akerlof’s (1982) gift-exchange, the wakalah fee reduces the adverse selection problem; and the wakalah fee could be used to protect infant takaful operators.
Highlights
Islamic insurance or takaful is a growing subsector of the Islamic finance industry
The compensation offered to a takaful operator (TO) is determined by a hybrid of (i) an agency contract known as wakalah; (ii) a profit-sharing contract known as mudarabah; and (iii) a surplus-sharing contract, where the operator receives a share in the insurance surplus and nothing in case of deficit
Even though the TO works for the policyholders, they do not have any say in deciding the compensation scheme
Summary
Islamic insurance or takaful is a growing subsector of the Islamic finance industry. not as vibrant as the Sukuk and Islamic banking markets, the takaful industry has consistently enjoyed a double-digit growth (World Takaful Report 2016). The framework is used to identify the strengths and weaknesses of each operational model, and how each of the competing operational models address the moral hazard (lack of incentives to induce the agent to work in the best interest of the principal) and adverse selection (lack of incentives to induce the TO to correctly price risks) problems associated with the nature of the takaful operation; and how to use these incentives to protect infant takaful operators This will hopefully serve as a guide to motivate sound regulations and converge the takaful model to the optimal structure identified through the analytical process used in this paper.
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