Risk management is of vital importance in islam and takaful

danger get laidment is of vital brilliance in islam and takafulABSTRACT insecurity circumspection is of vital importance in Islam and Takaful provides a right smart to manage dislodges in phone line according to Sharah principles. This explore paper attempts to identify assorted types of fortunes involved in Takaful business that strike functional and enthronement functions of Takaful hustlers across the globe and finds the ways to manage those finds usefully. However, takaful promoters practically verbalism difficulty in managing gras companyplace and deferred payment jeopardizes as Sharah submissive spirit of Takaful bowdlerise does non allow Takaful companies to deal with avocation assess and monetary derivatives that pack been unanimously considered repugnant to Sharah by Moslem jurists. This look into identifies Islamic pecuniary instruments like cooperative hedge and bi-lateral mutual valuation account that aim at providing mutual gains to bo th bities by the way of endangerment sharing and can be used as an pick to pompous derivatives. The research paper attempts to provide a framework to enhance lay on the line management culture among Takaful operators. It too discusses the disputes that wish to be encountered to enhance chance management practices among Takaful operators. INTRODUCTIONM all Muslims mis lowstand the c at one timept of fate. For some Muslims imagine that the future is in the hand of Allah, where they atomic number 18 facing with fatalistic mindset by moldting themselves in the doctrine, whether ane is rich or poor, golden or sad, it is fated by Allah. It is a good dealing with luck. In fact, efforts and prayers should precede this kind of belief (Iqtisad Al-islamy, 2003). For a long metre, same misconceptions own been associated with insurance. Muslim scholars and Islamic jurists constitute treated insurance illegal, haram and repugnant to Sharahwithout providing an option solution to Muslim Ummah. As a allow of these prevalent misconceptions, all effort or attempt management system to insure the assets or life has been considered against the fate and exit of Allah. In Islamic pecuniary planning, Takaful is a way to reduce the monetary jeopardy of passing game due to adventure and misfortunes (Iqtisad Al-islamy, 2003). As a matter of fact, Takaful plan is an alternative to the insurance in the established fiscal planning. In Takaful plan, the posticipant would pay particular sum total of money as contribution (k this instantn as the premium) partly to guess stock (the participants special account) utilize the concept of tabbaru (donation) and partly to a nonher fellowship (known as Takaful comp separately) with a mutual agreement that, the kafiil (Takaful attach to) is under a legal office to provide for the participant a financial protection against unexpected loss, should it happen within the concord period. The focus of this research pap er is to identify various types of take a chance of exposure of infections associated with Takaful business and devise criteria for managing gambles and enhancing assay management culture among Takaful companies. It alike discusses challenges to put on the line management in Takaful. jeopardy MANAGEMENT pre angle is the chance of happening of something that will have an impact upon our objectives. It is measured in terms of likeliness and consequences (GOWA, 2002). Traditionally, concept of risk has been associated with un certain(prenominal)ty of events in future. Higher the uncertainty of events, luxuriouslyer(prenominal) is the risk. In insurance, risk is the measurement of loss associated with property or life. Risk to property can be a loss or revile to car, building, house, and so on Risk to life can be described as poor health, premature death, bodily injuries as a leave buttocks of diagonal etc. (Rejda, 2006 p.23).Risk management is a run that identifies los s exposures go about by an organization and selects the most appropriate techniques for treating such exposures(Rejda, 2006 p. 63). accord to bran- in the altogether Zealand regular of Risk heed, It is the culture, processes and bodily structures that atomic number 18 directed towards the effective management of latent opportunities and adverse effects. In fact, risk management is an ongoing process that encompasses all aspects of our life.RISK MANAGEMENT UNDER SHARIAHRisk traditionally means possibility of joining danger or suffering, harm or loss (Iqtisad Al-islamy, 2003). Risk is an divisor of life in this world for being ignorant of the future. It is overly factor of droping that one should take time to understand prior to selecting any specialised investment instruments or any new adventures. Muslims be asked to work hard in revisal to be able to change their conditions as obvious in the verse of beatified Quran, Verily never will Allah change the condition of a stack until they change it themselves (with their own souls) (Quran 311). However, it is true that only Allah knows ones future and fate, Muslims should pass to achieve the goodness in this world and the here later. Submission to Allah, of course, has a corroborative effect on human behavior. For it will lead to peace and contentment. Undoubtedly, one has to submit every single thing to Allah, but it supposes to be after his hands stretch out to do the outdo effort as he can, to change himself, so that he would be able to manage and to cope with unforeseen calamities or misfortune. illusionist Muhammad peace be upon him once asked a Bedouin who had left his camel untied, Why do not tie your camel? the Bedouin answered, I put my trust in Allah the prophet then said, tie up your camel first then put your trust in Allah( Sunan al -Tirmizi, vol.4, no 2517, p. 668). This conversation depicts not only how should Muslims turn out their fate but it in any case indicates how do Muslims reduce the risk of loss and calamities.Quran has presented stories of the previous prophets so that Muslims can take the lessons from their experiences. The story of the prophet Joseph, for instance, tells us about financial planning. The story of Prophet Yaqub, Josephs father, tells us about the management of risks as Yaqub commanded his sons to infix Egypt from different gates. Quran states, Further he said O my sons autograph not all by one gate enter ye by different gates. Not that I can profit you aught against Allah (with my advice) none can command except Allah On Him do I put my trust and let all that trust put their trust on Him (Quran 1267).The history of the prophets migration to Madinah gives us another(prenominal) lessons on how the Prophet (SAW) managed the risk. The Prophet reduced the risk of getting assassinateed by asking Hazrat Ali (R.A.) to sleep in his bed during the night of emigration. It was reported that as night advanced, the Quraish posted assa ssins just about the Prophets house. Thus they kept vigil all night long, waiting to kill him the moment he left his house early in the morning, peeping now and then with a hole in the door to dupe sure that he was still lying in his bed.All these in a highschool place examples depict that risk management is in the roots of Islam. We, as a Muslims, should put our trust onto Allah only after meticulous planning and best utilization of all the available resources. NORMS OF ETHICS Obaidullah (2002, pp.2-4) has place norms of cleverness and ethical motive for Sharahestablish risk management in a business contract. These norms argon also applicable to Takaful contract and ar briefly described as act on Each party in Takaful contract should be free to accept the terms and conditions of the contract and no coercion is imposed on any party. Takaful contract should be free from element of riba (interest) that is prohibited by Shariah. whizz of the major objections on the contract of constituted insurance by Sharahscholars is element of riba in its investments for which it is considered illegal and unIslamic. There should be no uncertainty or ambiguity about the nature of contract. Excessive uncertainty is not tolerable in Shariah. For example, Sharahscholars disallow conventional insurance contract where no party clearly knows how and from where the insured amount is to going to be paid in object lesson a loss or catastrophe occurs to the insured. There should not be any element of gambling in Takaful contract. It means that Takaful contract should not be aimed at getting a huge improvement at the cost of others. Rather, participants should have sincere intention of helping each other in case of loss or catastrophe from a joint fund. Contribution amount for participants should be adequate and fair and should be determined by actuaries and approved by Sharahscholars. Takaful customers (participants) should have equal penetration to adequate, accurate and timely mart schooling connect to Takaful products and confederacys performance where they essential to contribute their money. Rights of any third party should not be adversely inciteed by Takaful contract between two parties. It means Takafulcontract should not be detrimental to any third party. There should be open-ended public interest in Takaful products and its business contract which should work for the foster of people at handsome.TYPES OF RISKS IN TAKFUL BUSINESSBusiness industry is prostrate to a number of risks. Five types of risks in business (Basel, 2006 IAIS, 2004) have been determine that argon relevant to Takaful business. First two types of risks (underwriting and operational risks) are nowadays related to operations of Takaful confederacy while remaining three ( recognise, liquidity state and market risks) are associated with the investment activities of the caller-out. i. Underwriting RiskUnderwriting risk is pertinent to insurance and Takaful. It occurs due to adverse infusion of applicants or due to re-Takaful risk as a result of inability of re-Takaful operator to adjoin the obligation towards ceded company under re-Takaful agreement (IAIS, 2003 pp.32-33). Adverse selection refers to the tendency of selecting applicants that result in higher than average chance of loss (Rejda, 2006 p. 45). The risk of adverse selection rustles when applicants with higher than average chance of loss succeed in obtaining Takaful reportage at standard rates e.g. high risk drivers or persons with knockout health problems. It results in higher call ratio and put the buckram on high fluidity constraints. Re-Takaful risk occurs as the ceded company mud liable for a portion of outstanding claim to the extent re-Takaful operator fails to provide financial protection to Takaful operator in accordance with hold terms. Both adverse selection and re-Takaful risk hamper the firms underwriting capacity untune the change flow pattern and henc e affect the stability of the pay of the company.ii. Operational RiskOperational risk is not a hearty defined concept , yet Basel Report (2006, p.144) defines it as a loss that occurs as a result of inadequate or failed innate processes, people, engineering or from external events.Internal processes failure occurs (Ahmed Khan, 2001 pp.29-30) as a result of inaccurate processing of proceedings, inefficient record keeping, violating operational control limits, non-compliance of regulations etc. people risk may occur due to incompetence of employees, cunning and failure to perform the duties. Technology risk may arise as a result of telecommunication system or computer cyberspace breakdown. Risks from external events include unenforceability of regulatory policies, legislation and regulations that affect the fulfillment of contracts and transactions in the organizations. These risks are also called legal risks and are considered a part of operational risks.iii. Credit RiskCredit risk occurs a result of default of counterparty when it fails to equalise its obligations in time and in accordance with agreed terms (IAIS, 2004 p.14).In case of insurance, credit risk may be treated as default risk, migration risk, dispersed risk or engrossment risk. Default risk occurs when Takaful operator does not receive or partially receive silver flows or assets to which it is entitled because the other party fails to meet the obligations of the contract. Migration risk occurs when probability of a future default of an obligator adversely affect the contract today. Spread risk occurs due to market perception of change magnitude risk on either macro or micro basis. parsimony risk is the result of increased exposure to losses due to soaking up of investments in a particular geographical area or scotch or industrial sector. Takaful industry is also exposed to these risks. iv. Liquidity RiskLiquidity risk is the risk resulting from Takaful companys inability to meet its obligations (i.e. claims payments and maturity impairment of policy) when they fall due. This risk occurs because the company has insufficient liquid assets or high level of liabilities (IAIS, 2004 p.18). Liquidity risk includes colony risk, affiliation investment risk and capital funding risk.Liquidation value risk is the risk under circumstance when assets are liquidated below their real (market) value. Affiliated investment risk is the risk that investment in an affiliated or member company aptitude result in drain of financial or operational resources. Capital fund risk is the risk that insurance company will not be able to outsource funds in case of large claims. Takaful industry, just like conventional insurance company, brass sections similar types of liquidity risks. v. merchandise Risk market place risk is the volatility of impairments in instruments and assets of Takaful company in the market. It can be classified as equity worth risk, interest rate risk, current ness risk and commodity price risk (IAIS, 2004, p.12). Equity price risk is the risk of loss resulting from changes in market price of equities or other assets. Interest rate risk is the risk of loss resulting from changes in interest rates that adversely affect the cash flows of the insurance company. Currency risk is the risk of loss resulting from volatility of transposition rates that adversely affect the operations of insurance company. For a Takaful company, it does not include interest rate risk, however Takaful operators are exposed to mark up price risk as avoidance of interest based transactions is distinctive feature of Sharahcompliance.MANAGING RISKSAll types of risks in Takaful require specific risk management strategy and exigency to be managed on single(a) basis.i. Underwriting Risk ManagementUnderwriting risk can be managed by establishing standard selection use consistent with the companys objectives. Most of the Takaful operators require physical surveillance or medical reports of the applicants that have serious health problems or flat to higher than average risk. Some have introduced computerized underwriting system to standardized underwriting procedure and minimizing the chance of adverse selection. For example, Takaful Ikhlas Sdn. Bhd. of Malaysia uses computerized underwriting procedure for motor Takaful where applicants who meet standard requirements are automatically selected for Takaful. Others are rejected or alternatively are offered higher contribution rates for the extra risk. To minimize re-Takaful risk, Takaful operator can treasure the financial strength of re-Takaful operators in the region and diversify the risk geographically by making arrangements with much than one re-Takaful operator. ii. Operational Risk ManagementManagement of this risk is more complex as it arises from failure of natural processes, people, information system breakdown and non-compliance with regulatory standards (Ahmed Khan, 2001 pp. 38-39). Senior management and poster of directors of Takaful company should devise policies and develop strategies to manage and reduce operational risks. Sources of operational risk (i.e. people, processes and engineering science) should be handled carefully. This raises the importance of corporate g all overnance culture in the organization. Given the newness of Takaful industry, computer software available for conventional insurance might not be appropriate for Takaful industry. This calls for recruiting talented professionals in the field of informational technology so that they could develop software to meet peculiar needs of Takaful industry. freelance external analyseors can also play an important role in mitigating operational risk as they point out blurs in familiar processes of the organization. This calls for proper disclosure of activities and independent and secure reporting system. iii. Credit Risk ManagementUnder conventional insurance system, credit exposure limits ar e established within companys investment policies to mitigate and manage default risk, migration risk, spread risk and concentration risk as discussed under credit risk. Usually, by-line credit exposure limits can be established for insurance company investment and credit activities (IAIS, 2004 pp.16-18). Internal and external rating of counterparties Limit on maturity of credit facility (prefer short term credit over long term credit) Limit on maximum investment amount or a certain percentage of investment exposure to a single issuer, industry, geographical region or some other risk classification.Prohibition of interest does not allow Takaful companies to investment in interest-based instruments (Chapra and Khan, 2000). Moreover, Takaful companies do not have access to credit derivatives that are considered effective instruments for credit risk mitigation. Yet Al-Suwailem (2006 pp.67-68) argues that futures and Option contracts result in losses for more than 70% of the time and h ence such instruments are considered as factors of loss, not of gain. The non-availability of Islamic derivatives raises the importance of internal control mechanism for Takaful operators which ensures that credit risk exposures are maintained within limits of prudential standards defined by internal controls.iv. Liquidity Risk ManagementIAIS Report (2004, p.20) identifies two approaches in order to hedge liquidity risk that are also applicable to Takaful industry. These are Cash flow framework Liquidity ratiosCash flow modeling is done in order to assess the amount of deficit, surpluses or liquidation value risk in order to meet the needs of Takaful industry. Takaful operator should make sure that it has sufficient liquid assets in order to meet liquidity risk and unexpected liquidity requirements.Use of liquidity ratios will help Takaful operator to set the amount of liquid assets required to meet demands of liability portfolio, desired level of liquidity ratio will also help in determining Takaful operators investment policies.Capital funding risk could be mitigated by setting contingency plans and drawing cash from re-Takaful policies. This form of liquidity hedging could be recognized by designed current level of liquid assets in hand to meet Takaful operators investment policies. In order to identify and evaluate liquidity risks, Ahmed and Khan (2001, p.38) punctuate the need of adequate internal control and proper disclosure of information in the organization. Towards this end, it is essential to have regular independent reports and internal audit function should periodically critique the liquidity risk management process.v. Market Risk ManagementIn conventional insurance, management of market risk includes devising strategies to manage interest rate risk, exchange rate, and commodity price risk as salutary as equity price fluctuations. Takaful operators are not involved in interest based transactions so they do not face this risk. However, KIBOR (Karachi Inter Bank Offered Rate) can be used as bench mark for markup in Islamic financial institutions in their financing activities.Conventional institutions manage the market risk using financial derivatives such as futures, forward, option or swap contracts (Chapra Khan, 2000 p.55). Takaful operators face difficulty in managing market risk as these financial derivatives are not compatible with Sharahin the eyes of Islamic scholars. However, according to Al-Suwailem (2006 pp.118-126), cooperative hedging and bi-lateral mutual adaptation are acceptable instruments under Sharahto mitigate currency risk and interest rate risk respectively. Additionally, Takaful operators could apply stress tests and look on at Risk (VaR) techniques to mitigate commodity price risk and equity risk. Stress testing is one of the risk management tools that can be employed to assess the vulnerability of portfolios to abnormal shocks and market conditions. Value at Risk is the probability of portfoli o losses exceeding some specified proportion.ENHANCING RISK MANAGEMENT CULTURE Cultivation of risk management culture is passing important to form a robust and resilient Takaful industry in Pakistan. This objective, however, could not be achieved without active participation and collaboration of regulatory authorities, elderly management of Takaful companies and members of SharahSupervisory Board (SSB). Towards this end, regularities authorities should make sure that stress testing and Value at Risk (VaR) reports as identified above are regularly produced and obtained from senior management of Takaful operators in summation to reports of Takaful risks. Regular review of these reports will greatly facilitate the regulatory authorities as well as Takaful operators to enhance risk management practices in Takaful industry.Moreover, effective writ of execution of internal control and corporate political science system could prove to be of vital importance to Takaful operator as wel l as to touch on regulatory authority. It will help the authorities in effective supervise of Takaful activities and managing different types of risks hence enhancing the functioning of Takaful operators in the industry.Figure 1 shows the locomote for effectively manage the risks in Takaful business. In the first step, possible risks in the way of Takaful business are identified. In the second step, strategies are essential to cope with and manage the risks effectively. In the third step, process of identification and strategy formulation and implementation related to each type of risk is examined through review reports and effective measures are taken to counter any flaw or discrepancy in the previous process.CHALLENGES TO RISK MANAGEMENT In spite of effective risk management techniques discussed above, there are certain challenges in the way of risk management for Takaful.i. Internal ControlsInternal controls are indispensable for recognizing and assessing risks faced by finan cial institutions including Takaful companies. Basel Committee (2005) and IAIS (2006a) reports have cerebrate on the importance of internal controls for banking institutions as well as for conventional insurance companies respectively. Chapra and Ahmad (2002) found that existence of effective internal control have prevented the financial institutions from systemic crisis and enabled them to have early detection of problems and associated risks they might face in future. These experiences highlight the importance and need of internal controls for Takaful companies. Unique nature of these companies from conventional insurance demands the fulfillment of Sharahaspects. IFSB and IAIS joint working group (2006) maintains that to have effective internal control mechanism, Takaful companies must ensure Sharahcontrols in addition to all statutory regulations. It urges the need of a regularSharahaudit as a part of an on-going internal control system.ii. Corporate GovernanceThe corporate gov ernment activity structure specifies the distribution of rights and responsibilities of the Board, manager, shareholders and other stakeholders (OECD Report, 1999) yet effective corporate governance ensures the license of board of directors ( body-build) who in turn devise polices and implement strategies for risk management and hold the management accountable to shareholders (Psaros and Seamer, 2002 p.7). Lack of an effective corporate governance framework hampers the independence of board of directors (BOD) and hence poses a challenge to risk management. It in turn increases the operational risk which might result in failure of operations due to inability of BOD to implement unbiassed and independent decisions for the best interest of all stakeholders. Takaful companies are confronted with an additional challenge related to corporate governance of SharahSupervisory Board (SSB). Grais and Pellegrini (2006b) identify corporate governance issues that affect their role and functioni ng in the organizations. It calls for a greater need to incorporate corporate governance culture to overcome related issues of Takaful industry. iii. SharahBased ChallengesAccording to Ahmed Khan (2001), most of the risk management techniques are not applicable to Islamic financial institutions due to the requirements of Sharahcompliance. It creates Sharahbased challenges to risk management for Takafulcompanies as well. These challenges arise as Sharahrestricts the use certain instruments that are considered useful in conventional risk management e.g. derivatives (futures, options, swaps etc.) and sale of debts. Al-Suwailem (2006, pp.89-90) argues that Sharahconstraints to human behavior do not blockade creativity, rather these constraints are the major driving force behind the creation of innovative financial instruments. He suggests several Islamic financial instruments for risk management and concludes that Sharahis abundant with real solutions to the present problems of gambli ng and speculation. It provides directions to Sharahscholars and experts of Islamic finance to explore the dimensions of Sharahin order to integrate risk management practices with value creation.iv. Financial EngineeringFinancial engineering aims at designing new and innovative Sharahcompliant Islamic financial instruments for IFIs including Takaful companies. Chapra and Ahmad (2002) maintain that financial engineering has emerged as the greatest challenge faced by Sharahscholars of present time as it poses major threat to IFIs to become competitive in the contemporary business environment. Process of giving fatwas by Sharahscholars regarding the permissibility of a financial instrument is preferably slow and over-conservative (Iqbal et al, 1998 pp.47-48) as Sharahscholars and experts of modern finance have different schoolman backgrounds. They use technical terms related to their own field that are most of the time not easily understandable to other party. The need is to produce scholars with Sharahbackground that also have working knowledge of modern finance to meet the acute challenge of financial engineering. v. Islamic Financial MarketIslamic financial market provides a secondary market for job of Islamic financial instruments. In the absence of this market, it will be extremely difficult for Takafulcompanies to maintain its liquidity position to make prompt claim payments when they become due. Retaining a large portion of Takaful fund to maintain high liquidity ratio will affect the efficiency of the firm and its competitiveness as compared to conventional insurance companies that have ready access to liquid bonds and t-bills. Islamic Financial Market will greatly facilitate the Takafulcompanies to invest large portion of their fund in Islamic financial instruments and change magnitude their efficiency and competitiveness while maintaining low liquidity ratio. It will also help Takaful companies in hedging market risk by providing alternative instru ments to financial derivatives that are not acceptable under Shariah.vi. Need of surreptitious Credit Rating AgenciesAlthough International Islamic Rating Agency (IIRA) has been set up in Bahrain to judge the Sharahcompliance and financial strength of Islamic financial institutions (IFIs) including Takaful companies, it is not be possible for IIRA to rate thousands of counterparties with whomTakaful companies deal. Consequently, it calls for the need of private credit rating agencies in each Muslim country that could provide information related to financial strengthen, fiduciary risk and credit worthiness of thousands of counterparties that in private issue financial instruments (Chapra Ahmed, 2002 pp.80-81). This information could provide great help to IIRA in rating these companies and make it readily available to Takaful companies and other interested parties. outcome AND RECOMMENDATIONSRisk management is of vital importance in Islam and Takaful provides a way to manage risks in business according to Sharahprinciples. Five types of risks have been identified in Takaful business that affect operational and investment functions of Takaful operator. Operational risk can be managed by enhancing corporate governance culture in the organizations. Cash flow modeling and use of liquidity ratios is quite face-saving to identify liquidity constraints. Takaful operators might face difficulty in managing market and credit risks asSharahcompliant nature of Takaful contract does not allow Takaful companies to deal with interest rate and financial derivatives due to their speculative nature by which they tend to benefit one party at the loss of other. On the other hand, Islamic financial instruments like cooperative hedging and bi-lateral mutual adjustment aim at providing mutual gains to both parties by the way of risk sharing. Risks associated to Takaful have raised several challenges that need to be encountered to enhance risk management practices. Regular Sharahau dit is found to be an integral part of effective internal controls that prevent the companies from systemic crisis. Corporate governance calls for independence of BOD to devise policies for effective risk management, make unbiased decisions and resolve issues related to functioning of SSB. Sharahbased challenges call for devising innovative Islamic financial instruments as Sharahis abundant with real solutions to present business dilemma and does not hinder creativity. Exploring those solutions will help to meet the challenge of financial engineering. Islamic financial market will greatly facilitate the task of Takaful companies to invest large portion of their fund in Islamic financial instruments and increase their efficiency and competitiveness. There is need to establish private credit rating agencies that could supporter IIRA to rate thousands of counterparties for the benefit of Takaful operators.