Bermuda: Crossroads for Takaful Opportunities

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1 BERMUDA BRITISH VIRGIN ISLANDS CAYMAN ISLANDS CYPRUS DUBAI HONG KONG LONDON MAURITIUS MOSCOW SÃO PAULO SINGAPORE conyersdill.com December 2010 Bermuda: Crossroads for Takaful Opportunities Bermuda is positioned to play a key role in the swiftly growing Islamic insurance, or takaful, industry. Lying some 660 miles east of the North American coastline and settled by shipwrecked British sailors on their way to Virginia in 1609, Bermuda s size and location belies its status as a leading risk capital. Bermuda has a sophisticated legal system rooted in English law. Its success as an insurance centre is largely attributable to its effective regulatory system, overseen by the Bermuda Monetary Authority (BMA). Cooperative interaction between industry and the BMA has resulted in a regulatory framework that is innovative, responsive and transparent. This regime, combined with a deep pool of insurance expertise, allows Bermuda to keep pace with global developments in the marketplace. In widely reported comments made at the Bahrain/Bermuda Conference on Global Financial and Insurance Services in July 2010, now Premier Paula Cox said that Bermuda s Government and private sector are actively involved in promoting the development of Islamic finance in Bermuda, and would welcome the development of takaful. By tapping into Bermuda s resources, takaful and retakaful operators should be able to leverage access to capital as well as systems, products and expertise. This note considers how takaful and retakaful operations might be structured in Bermuda. Key Elements of Takaful While Shari ah scholars generally recognise the role of insurance in economic growth, conventional insurance poses a number of problems for Shari ah purposes including potential for uncertainty, excessive profit, usury and gambling. Takaful has developed as an alternative, and from niche beginnings has swiftly become mainstream.

2 The key distinction between takaful and conventional third party insurance lies in the relationships between the insurance company and the policyholders. Takaful is an arrangement amongst participants (policyholders) who agree to indemnify each other against certain loss or damage. To this end, they pool their contributions (premiums) into a common fund to pay compensation (claims). There is no transfer of risk as such; all participants share in the profits and losses of the operation, with the participants giving up individual rights to gain collective benefits. Commercial takaful arrangements are managed on a for profit basis by a third party (the takaful company, or operator). However, the shareholders of takaful operators (unlike those of conventional non captive insurance companies) do not pocket all of the profits from the arrangement. Rather, the operator serves as agent and representative of the participants, and its role is effectively that of manager and entrepreneur. It collects the participants contributions, and for a fee, manages and invests them on behalf of the participants, who are entitled to share in the surplus generated. In effect, the operator maintains two separate and distinct accounts or funds : (i) the takaful fund, which includes the participants contributions; and (ii) the operator s fund (also known as the shareholders fund) which generally includes shareholder reserves and capital. The segregation of the funds is central to Islamic insurance. The takaful fund is available for capital adequacy requirements and is invested by the operator on a Shari ah compliant basis. Any deficit is covered by an interest free loan (Qard Al Hasan, or a Qard loan or facility) from the operator s fund, the terms of which generally depend upon capital adequacy requirements. As the loan may be repaid out of future surpluses, the only risk assumed by the operator typically is non repayment in the event of a failure to generate such surpluses. The operator s fee is based on a proportion of contributions and/or a share of the underwriting surplus or investment profits, depending on the operating model. Wakala and Mudaraba, or a hybrid of them, are the models used by most commercial takaful operators worldwide. The difference lies in the status of the operator and how the operator s remuneration is calculated and paid. Either way, there must be no guaranteed level of income so as not to conflict with Shari ah principles. Under the Wakala model, the operator is regarded as an agent and earns a fee for its services, which may include management and performance incentive components. Under the Mudaraba model, the operator is an investment partner of the participants, and is entitled to a share of profits derived from investing the fund as well as any underwriting surplus. The hybrid model incorporates a Wakala Page 2 of 12

3 arrangement in respect of underwriting activities and a Mudaraba arrangement in respect of investment activities, and there is growing consensus that it be considered the leading practice for commercial takaful operations. Other Distinguishing Elements The operational policies and terms of a takaful arrangement must comply with Shari ah. Amongst other things, these restrict the manner in which operators can invest takaful funds. For example, investments generally must be by way of equity or profit participating loans, rather than interest bearing debt (as a result of a prohibition on usury), and must take into account the debt/equity ratio of the underlying investment entity. In addition, investments may not be made in businesses that are not ethically sound or are involved in impermissible activities (such as conventional financial services, alcohol, gambling, armaments, tobacco and pork). Also, while takaful employs many principles in common with conventional insurance, the application of Shari ah principles can mean that insurable risks, valuation requirements and other terms may differ when compared with conventional insurance. While takaful operators are rated so far as possible in the same manner as conventional insurers, ratings agencies (such as A&M Best, Standard & Poors and Moodys) by necessity use somewhat modified methodologies. For example, given the comparatively restricted investment policy of a takaful company, its higher levels of counterparty risk and higher than average proportion of equity holdings, capital and balance sheet strength requirements are often significantly larger than for a conventional insurance company. Reinsurance and Retakaful Like conventional insurers, takaful operators habitually obtain reinsurance protection on behalf of the participants. Retakaful is reinsurance based on takaful principles. It operates in the same way as takaful, except that the participants are takaful operators or other retakaful operators. The distinction between the operator s fund and the retakaful fund is maintained, and each is ring fenced from the other. In this way risk is pooled, rather than transferred, as a means of limiting exposure since (like conventional quota share or surplus reinsurance) the reinsurer becomes a coinsurer of the original risks. It is widely acknowledged that the lack of rated Shari ah compliant reinsurance carriers is limiting the growth of the takaful market, which continues to rely on Page 3 of 12

4 conventional reinsurance based upon the Shari ah doctrine of necessity (scholars accept that there is insufficient retakaful capacity, and that conventional reinsurance is therefore necessary for the takaful industry to survive). The doctrine s application is limited, and will be tested as more retakaful operators emerge. As takaful operators may be expected to cease purchasing conventional reinsurance coverage when retakaful capacity becomes available, many leading reinsurers are developing retakaful facilities. In view of the increasing appetite for competitively priced retakaful products, the development of a global retakaful centre seems a likely if not inevitable step for the industry. While there is scope for Bermuda based insurers to enter the primary takaful market, it is Bermuda s capacity to cater to the growing demand for retakaful that highlights its ability to contribute to the development of the global industry. Bermuda Insurance Regulation Any company carrying on insurance or reinsurance business in or from within Bermuda must be registered (i.e. licensed) by the BMA, and this requirement would apply equally to a takaful or retakaful operator (reinsurers are regulated in the same way as direct insurers). Insurance business is divided into general, long term and special business, and the appropriate class and applicable regulatory requirements for any takaful or retakaful provider would depend upon its proposed activities. To reflect the breadth and diversity of the market, there exists a multi class licensing system for general business, ranging from pure captives (i.e. single parent captives writing risks of parent and affiliates only) to very large commercial insurers writing excess liability or property catastrophe business (subject to the strictest regulations on capital, solvency and liquidity). This allows for a graduated approach for solvency and liquidity margins and reporting standards depending on the amount of unrelated risk. Bermuda law also provides for the licensing of special purpose insurers (essentially a disposable or single transaction company), which benefit from less stringent regulation and a faster track to registration. Bermuda insurers are allowed considerable flexibility in their investment policies. While statutory capital and assets tests must be met, there are no restrictions on the proportions in which different categories of qualifying assets may be acquired and held. This could be advantageous for takaful operators, which by definition have more restrictive investment policies than conventional insurers. It also should be noted that certain categories of assets which do not automatically qualify as relevant assets for general business (such as unquoted equities and real estate) may on successful application to the BMA by the insurer be designated as relevant. This provides considerable scope for focus on Shari ah compliant asset classes. Page 4 of 12

5 Dividends may be declared and paid by Bermuda insurance companies provided that relevant liquidity and solvency margins are met and the solvency requirements under Bermuda company law are satisfied. As a consequence, Bermuda companies enjoy greater freedom to declare dividends than their counterparts in many other jurisdictions. Bermuda Structures for Takaful Operations As with conventional insurance, takaful participants vary from corporations wishing to manage business risk to individuals wishing to take out personal policies. Accordingly, there is no one size fits all approach and the most suitable structure will depend on the product in question. In this regard, Bermuda law provides significant flexibility with respect to corporate structures and governance. However, it is likely that elements of traditional captive and third party insurance arrangements may facilitate takaful arrangements. Captives Captives are privately owned insurance companies, and range from single member captives to group or association captives, which have more than one owner, and from pure captives (which insure only risks emanating from their parent and affiliates) to captives which also underwrite a limited amount of third party risk. Conventional captive management is typically outsourced by all but the largest of businesses, and specialist takaful captive management services could also be subcontracted where necessary. With the exception of single member captives (which would lack the necessary element of mutuality), captives are well suited to takaful arrangements. The benefits of captive insurance are manifold. By setting up a captive, companies generally are not aiming to make a profit, but rather to provide themselves with low cost insurance coverage. Captives can facilitate the reduction of insurance premium costs, mainly due to the profit margins and overhead expenses of commercial insurers and the direct access they allow to reinsurers, and allow full utilisation of cash (premiums) which would otherwise be payable upfront to third party insurers. Captive insurance is also more flexible than traditional third party insurance, because the proportion of risk to reinsurance can be adjusted to market conditions. Perhaps one of the biggest benefits is that excess net premiums can be recouped by the owner(s) when claims are low, and reinsurance can be increased in riskier areas. In addition, the owner(s) can dictate the procedure by which claims are processed. Page 5 of 12

6 The majority of captives in Bermuda are set up as companies limited by shares, although a small number of multi owner captives are set up as mutuals (often cited as the conventional counterpoint to takaful). These are companies without share capital authorised to carry on insurance or reinsurance business on the mutual principle, meaning that their members, who are exposed to some contingency, contribute premiums on the basis that if the contemplated contingency befalls any member he will receive a compensatory payment. Since the solidarity principle is already built into the structure, it is easy to see how the mutual concept aligns to takaful. Commonly used in Bermuda for groups of ship owners or professional firms, a mutual structure could be used by any group of persons sharing similar exposure. In general, captives are best suited to operations with a relatively small number of participants, as the operation cannot exist until the founders have come together and pooled their contributions. Because of the limited pool of insureds, a pure captive writing solely related risk can only be created by a company or group of companies with the financial resources to contribute all of the original capital to the captive. The use of captives in takaful business is therefore likely to attract smaller groups of participants with access to significant capital reserves. Bermuda law allows captives to be capitalised through equity, debt or contributed surplus, which in the case of a Shari ah compliant captive, would need to be structured subject to the usual Shari ah considerations. To the extent that further capital is necessary and is unavailable from the owner participants, a Shari ah compliant captive would need to access capital by way of a Qard through a takaful operator or through some form of Islamic financing arrangement. In this regard, an independent conventional insurer could potentially enter into a joint venture with a Shari ah compliant captive. The relevant joint venture agreement could provide for remuneration in respect of the management, licensing, underwriting and investment activities to be carried on. The parties also could agree on the establishment of a Qard facility or some other form of Shari ah compliant capital, provided that any issues of corporate benefit that may arise in this regard are addressed. While there are a number of possibilities for such a structure, the chart in Fig. 1 shows how a captive might work in such a joint venture. In the example given, the captive remains the owner of the takaful fund which is managed on its behalf by an operator on the basis of Wakala/Mudaraba. Page 6 of 12

7 Fig. 1: Joint venture between captive and third party operator (based on Wakala Mudaraba hybrid model) Third party arrangements A conventional non captive insurer is not owned by the policyholder(s), and underwrites mainly or exclusively the risks of third parties. While conventional noncaptive insurance contracts typically contravene Shari ah principles, what such arrangements have in common with most commercial takaful schemes is the lack of an ownership interest by the policyholders in the insurance company or operator. In both cases, the policyholder (or takaful participant) pays money to an unrelated insurance company (or takaful operator), and in return, is entitled to make a claim for his loss should the covered risk materialise. In the case of takaful, Shari ah compliance typically is achieved through the relevant contractual arrangements and appropriate provisions in the operator s constitutional documents. It should be possible to set up third party (re)takaful arrangements in Bermuda along the lines of what is done in other jurisdictions that have embraced takaful. The takaful operator might be an established (re)insurer in Bermuda, or a newly licensed overseas (re)insurer or (re)takaful operator. In a joint venture situation, the operator might be the vehicle for a partnership between an established conventional (re)insurer with access to capital resources, and an overseas (re)takaful operator with the requisite technical expertise. Such partnerships with established conventional (re)insurers are often cited as a potential solution to the thorny issue of capitalisation. As with conventional insurance, participants might range from individuals to large corporations according to the product. Page 7 of 12

8 In order to conform to the requirements of takaful, the operator would not be entitled to all of the profits from the operation, but neither would it bear all the risk. Under the Wakala/Mudaraba hybrid model, the operator would be entitled to its Wakala underwriting fees and/or its Mudaraba profit share, and against the possible need for drawdowns under the Qard facility, the right to recover any advances out of future years profits. The diagram in Fig. 2 shows how such a model might work in Bermuda. This has been structured so that the company which holds the takaful fund is incorporated as a subsidiary of the operator, but this might not be necessary depending on the circumstances (e.g. if the operator is already established and licensed in Bermuda). Bermuda law allows for a variety of arrangements that might be considered in connection with the (re)takaful fund. For example, it might be held on a ring fenced basis that is purely contractual, through a trust or in a segregated accounts company. Care would need to be taken to ensure the arrangement remains Shari ah compliant even on a dissolution or winding up of the operator, since surplus in the (re)takaful fund must not revert to the operator or any liquidator of the operator (other than to settle amounts to which the operator is contractually entitled). Fig. 2: Third party arrangement (based on Wakala Mudaraba hybrid model) Page 8 of 12

9 Additional structuring options The Segregated Accounts Companies Act 2000 (SAC Act) sets out rules governing the operation of segregated accounts. While separate accounts to manage risk may be created contractually, SACs are an increasingly popular option for insurers who need to differentiate between categories of risk and accordingly register under the SAC Act. Conceptually, SACs are like honeycombs, where risks are placed in separate accounts, or cells, which are kept separate from each other and from the general account of the insurance company. SACs are widely used in Bermuda for rent acaptives, which allow a company without the resources or inclination to form and operate its own captive to rent a licensed cell and provide capital to back the risk. The service provider will pay the insured a percentage of the underwriting profits or charge the insured for underwriting losses. It is not uncommon in Bermuda for the insured to hold a class of shares in the SAC, but this is not a requirement. Given that the takaful fund must be kept entirely separate from the funds belonging to the operator and there can be no cross contamination of assets and liabilities, a SAC could be a useful takaful structuring tool. A SAC could be used wholly for takaful business, or by a conventional (re)insurer who wishes to operate a takaful or retakaful window without having to incorporate and license a new entity. Since takaful operators receive fee income which will by definition be Shari ah compliant, operators may wish to diversify by offering Shari ah compliant securities, which would give them the option of accessing the Islamic capital markets. Such instruments could play a part in an increasingly diversified Islamic capital market. The potential to operate SACs may be advantageous in this regard. In addition, while we do not consider that Bermuda s existing legal and regulatory framework would pose any substantive obstacles to takaful, it is worth noting that it is possible to petition the Bermuda Parliament for private bespoke legislation to give enhanced flexibility, and a number of Bermuda reinsurers and financial institutions are governed by private act. Additional Issues Arising Shari ah compliance The requirement to ensure compliance with Islamic principles arises in every takaful structure. While contractual and constitutional documents will be subject to any Page 9 of 12

10 secular laws which may apply (by choice or by operation of law), they also must conform to Shari ah. The BMA is of course a secular regulator. However, even in Islamic countries where takaful is expressly regulated, the regulator typically does not determine whether an arrangement accords with Shari ah. Rather, this requirement is devolved to a committee (generally referred to as a Shari ah board ) established by the takaful operator, and the regulator requires the operator to provide evidence that the board has been established and has signed off on the arrangement. It is to be expected that the BMA would impose a similar requirement. The Shari ah board comprises an additional layer of internal regulation, and does not replace the board of directors or other conventional corporate governance requirements (although the board of a takaful operator may either include Shari ah scholars and/or appoint a separate committee of Shari ah scholars). The global shortage of recognised Islamic scholars in the insurance arena and lack of consensus on what constitutes Shari ah compliance has been highlighted by many commentators as a challenge to the development of the industry. While clearly a consideration in Bermuda, such matters usually can be addressed remotely, especially by insurers who have offices in Muslim countries. To the extent that physical presence is required, Bermuda enjoys relative ease of access via both Europe and North America. Enforcement As a self governing overseas territory of the United Kingdom, Bermuda s legal system is based upon that of the United Kingdom, and decisions of the English and other commonwealth courts are highly persuasive. The Supreme Court of Bermuda is the first instance court in Bermuda, exercising unlimited jurisdiction. An appeal lies as of right to the Court of Appeal for Bermuda and thereafter, in more limited circumstances, to the Privy Council. The question arises as to how the Bermuda courts might deal with disputes involving takaful contractual arrangements, a point highlighted by the recent English High Court ruling on an appeal from summary judgment in The Investment Dar Company KSCC v BLOM Development Bank SAL [2009] EWHC 3545 (Ch). The case concerned a wakala contract governed by English law pursuant to which BLOM made certain investments with Investment Dar (referred to as TID). TID claimed that the wakala was non compliant with Shari ah (in that it amounted to taking deposits at interest), and as such was ultra vires, notwithstanding that the contract expressly waived the right to argue non compliance and that TID s Shari ah committee had authorised the form of contract. The court ruled that TID had raised arguable issues Page 10 of 12

11 in its defence that ought to be explored at trial. While no substantive trial has taken place, the ruling has led to some confusion in the industry. In this regard, it should be noted that the court did not suggest that previous authorities, to the effect that the terms of an English law document (albeit one intended to comply with Shari ah) would be construed in accordance with English law, would not be followed. Rather, the court accepted that an ultra vires argument (relevant as a matter of the law of incorporation of the relevant party) based upon non compliance may be considered. As is the case with other Islamic finance transactions, a lesson learned from the TID case applicable to takaful operations is that one should not rely solely on the approval of a Shariʹah board to establish compliance. While obviously not unique to takaful or Islamic finance matters, it is key to ensure that the transaction is within the objects of the relevant company and conforms to other provisions in its constitutional documents, although additional steps should be taken, including requiring parties to waive any defence of non compliance and/or to obtain independent Shariʹah advice. Further, contractual clauses dealing with choice of law and jurisdiction should protect as far as possible against potential challenge. It should be noted that substantive contracts involved in setting up and operating a takaful arrangement involving a Bermuda entity (including the Wakala and/or Mudaraba contracts and the Qard loan facility) generally need not be governed by Bermuda law, other than in relation to matters such as capacity, which are of necessity governed by local law. The Bermuda courts generally recognise the validity of foreign choice of law provisions and submission to the jurisdiction of overseas courts and tribunals. To the extent that judicial resolution of disputes may be inappropriate, the parties could provide for arbitration. It stands to reason that only tribunals with takaful expertise should hear cases involving potential default in takaful arrangements based on Shari ah principles. The Way Forward Despite the growth predictions for takaful, it has suffered during the downturn alongside the rest of the insurance industry. Nonetheless, projections suggest that takaful is set to remain the fastest growing area of insurance in the world, including in Western countries. As a jurisdiction with a potentially advantageous legal and regulatory framework, an established captive insurance and reinsurance market and an interest in opening up to Islamic capital markets, Bermuda provides a unique opportunity for the (re)takaful industry and vice versa. Page 11 of 12

12 The authors gratefully acknowledge the kind assistance of Peter Hodgins, partner at Clyde & Co, Dubai in reviewing the article. Claire McConway Associate +1 (441) m Kerri Lefebvre Director This article is not intended to be a substitute for legal advice or a legal opinion. It deals in broad terms only and is intended to merely provide a brief overview and give general information. About Conyers Dill & Pearman Conyers Dill & Pearman advises on the laws of Bermuda, British Virgin Islands, Cayman Islands, Cyprus and Mauritius. Conyers lawyers specialise in company and commercial law, commercial litigation and private client matters. Conyers structure, culture and expertise enable responsive, timely and thorough service. Conyers provides clients with the highest quality legal advice from strategic global locations including offices in the world s leading financial centres in Europe, Asia, the Middle East and South America. Founded in 1928, Conyers comprises 600 staff including more than 150 lawyers. Affiliated companies (Codan) provide a range of trust, corporate secretarial, accounting and management services. For more information please contact: Naomi Little +1 (441) naomi.little@conyersdill.com Page 12 of 12