The following article first appeared in the February 2009 edition of AsianInvestor magazine. Each month we offer online a feature from the magazine. To subscribe for more in-depth industry analysis that you can't find on our website, please send an e-mail to: [email protected]. 

Islamic insurance companies whose practices follow sharia principles are moving into the mainstream of global finance as orthodox, Western-based peers see their influence deteriorate amid the global financial crisis.

Such insurers practice the takaful concept - the word is a derivation of the Arabic kafalah, which means 'to guarantee one another' and suggests mutual cooperation. Although the concept has been around for 1,400 years, originating with Arab tribes pooling assets to cover various contingencies, its first modern realization came in 1979 in Sudan, with the founding of Salaam Insurance.

The industry really took off after 1985, when the takaful concept was blessed by a grand council of Islamic scholars. It fits a need in many countries that lack official pension systems.

Like Islamic banking, takaful is supposed to be about social justice, and therefore bans practices such as the use of interest (riba), uncertainty in business agreements (gharar) and speculation (maysir). Of course, such things are central to the modern financial model built in the West, which may explain why foreign insurance companies have found it difficult to expand into the Middle East.

Nonetheless the takaful concept has gone global, and today there are 133 such insurance businesses in operation. 22 are based in Southeast Asia and nine in South Asia. The most, 59, operate from the six nations of the Gulf Cooperation Council, but can be found in Europe, America, Africa and other parts of the Middle East.

PricewatehouseCoopers says takaful insurers could grow sixfold over the next decade, as new premiums should enjoy compound average growth rates of 20%. to $4 billion. Much of this growth will come from takaful subsidiaries of orthodox insurers including Allianz, Aviva, HSBC, Prudential (UK) and Zurich.

This growth is exciting but creates a challenge for these insurance companies: their coffers are overflowing. And whereas orthodox Western insurance companies have established asset-management practices, takaful insurers must also invest according to Islamic precepts. There are too few sharia-compliant assets in existence to meet their needs. In fact, there may be even fewer than industry players realize.

Assets in sharia-compliant investments total around $65 billion, according to financial services research firm Cerulli Associates, which is a figure that's more modest than the hundreds of billions of dollars often cited by regulators and investment managers.

In a report on sharia investing, Boston-based Cerulli notes that 53% of the assets, or $35 billion, is held in mutual funds. Specifically, $33.6 billion is managed by local fund managers, while $1.4 billion is managed by foreign fund managers.

The rest is held through foreign manager mandates (21% or $21 billion) and local manager mandates (16% or $10.4 billion).

Cerulli reckons only about 500 mutual funds are sharia-compliant, run mainly by fund managers based in Islamic countries (although multinationals do have significant holdings in Saudi Arabian asset-management companies). Few foreign fund managers have launched ranges of Islamic funds and the exceptions include HSBC Amanah, DWS Noor (part of Deutsche), and BNP Paribas.

International fund managers considering entering or expanding in the area of sharia investing face several key issues, according to Cerulli.

First, the market for sharia product is so far mainly retail, mass affluent, and in some places high-net-worth, driven primarily by religious considerations, although performance is also important.

As such, retail distribution is a major factor, and managers must contend with the closed architecture prevalent in many countries. Many fund managers are either a part of a bank or are legally separate from a bank but remain closely linked. Banks dominate sharia mutual fund distribution and Islamic banks, in particular, are expected to play an increasingly important role as they grow in scale and reach.

Second, equity products dominate in terms of asset size, and in most cases, these are local or regional products. Money- market or trade-finance products are also popular, especially in the Middle East, particularly Saudi Arabia. International fund managers have the potential to add value relative to local houses by offering global equity and global-themed products, especially as there is no shortage of sharia-compliant stocks in the world, Cerulli says.

Third, there is little evidence of institutions seeking sharia-compliant investments, and this is particularly the case with sovereign wealth funds (SWFs), Cerulli says. The SWFs' frequent ventures into American and European investment banks illustrate that sharia compliance is not an overriding concern for them.

This of course is not the case for takaful insurers or Islamic banks, which exist specifically to invest in sharia-compliant assets, but it does create a challenge of scale for product providers and portfolio risk management.

Risky business

To compete, particularly in markets such as Malaysia where orthodox insurers are common, takaful players must still find good investment returns. Their customers are going to demand takaful policies that include a savings and/or investment component that provide ample returns or adequate protection, notes Millie Leong, head of research at Malaysia Rating Corporation in Kuala Lumpur.

The shortage is most acute in fixed income. Malaysia is a big issuer of sukuk, bond-like structured, fixed-coupon instruments that adhere to sharia principles. Even so, there's not enough to meet the needs of insurance companies. Ernst & Young, when it audits takaful players, finds they are forced to invest in risk assets, with the average company allocating over 60% to equities and 10% to real estate or other physical assets. The situation will vary among countries but may be even more skewed in certain Middle Eastern markets.

This makes these insurance companies far riskier than orthodox counterparts, which tend to put the great majority of their assets into bonds, in order to be confident they can meet future obligations. In 2008, most insurers held Treasuries, which appreciated massively as a safe haven; takaful insurers would have mostly held equities, and probably equities from their domestic markets, which would have lost 50-65% in value.

It is therefore urgent for these insurance companies that the sukuk market becomes more liquid. Globally this market reached $90 billion in outstanding issuance at the end of 2008. This is a small size, but still doesn't reflect the magnitude of the problem, because there's no such thing as a global market. Each country issues sukuk based on one of four sharia schools of opinion, and these are usually not interchangeable. An insurer from Saudi Arabia can't necessarily invest in sukuk issued in Malaysia or Pakistan. Scarcity therefore makes sukuk very expensive, if you can find them at all, and international diversification is almost impossible.

The structured nature of sukuk - which are meant to derive value from an exchange of goods or services, not on the basis of interest - make them even more expensive in some markets. According to Teo Swee-Lian, deputy managing director for prudential supervision at the Monetary Authority of Singapore, because of the unique structure of Islamic transaction, takaful companies often attract double taxation on the sukuk and the underlying real-estate investments that usually underpin these structures.

Finally, takaful insurance companies, because of their small size and particular needs, do not attract experienced investment professionals. Although a petrostate can throw money at a fund manager trained in the West, this person may then lack a feel for the Islamic nuances that dominate decision-making. Better then to outsource, if the right expertise is available - a fact that many takaful players are still coming to grips with.

Still seeking scale

The market is desperate for more supply, but the complexity and sensitivity involved in sorting out sharia compliance across competing schools of thought poses a barrier to entry. Instead of trying to create funds that may prove difficult to market cross-border, these players prefer to tailor mandates to meet individual institutions' sharia-related requests.

The discretionary mandate business is estimated to be a $20 billion market today, and looks certain to expand, but potential providers are not diving in with product or pitches, because of lack of scale.
"Many fund managers are waiting for the markets to standardize," suggests Meredith Blakemore, marketing manager at FTST in Hong Kong.

So, all that needs to happen is for these sharia scholars to come up with a unified code, and scale will become a reality. But this is not simply a technical matter. Sharia is a code of religious laws and practices built not just upon the Koran, but also upon centuries of custom, the sayings and doings of the prophet Mohammed and his companions, scholarly reasoning and debate. To adhere to sharia practices is to live a just life as a Muslim. It's not the sort of thing that accepts compromises.

Not, of course, that various regulators across the Muslim world aren't trying. They recognize the need for scale and to develop the infrastructure of their financial markets, in which creating liquidity in sukuk is critical.

But the wait will be long. According to Andrew Cunningham, head of Middle East & Balkan Programmes at the Financial Services Volunteer Corps, a non-profit group that advises the Islamic Financial Services Board and various regulatory bodies, there is no evidence yet that such harmonization will happen any time soon.