Developments in the Rating of Takaful / Re-Takaful Companies.

Andrew Murray

Takaful SummitLondon, 1 July 2009

AgendaFitch’s Analytical Process

Focus on Selected Takaful Issues

Ratings in the Financial Crisis

AgendaFitch’s Analytical Process

Focus on Selected Takaful Issues

Ratings in the Financial Crisis

A Difficult Time for Insurance…

> Recent years have featured– Relatively benign claims

environment– Favourable investment returns– Good profitability– Strong solvency

> But, 2008 saw– Substantial investment

challenges– Weaker pricing– Continued support from reserve

releases– Increased uncertainty

Credit Spreads for Selected Major Insurers

0

100

200

300

400

500

600

Mar 08 Jun 08 Aug 08 Oct 08 Jan 09 Mar 09 May 09

(Basis points)

AXA Allianz Aviva Zurich Generali RSA

Source: Fitch RAPP, 1 year credit spreads

Lehman’s Bankruptcy, AIG supported by

Government

H208

The Building Blocks of Credit Risk

Loss Given DefaultProbability of Default

Expected Loss

Recovery Ratings (RR)The Recovery Rating (RR) is based upon the expected relative recovery characteristics of an obligation

Issuer Default Ratings (IDR)Issuer Default Ratings (IDRs) reflect the ability of an entity to meet financial commitments on a timely basis

Issue rating (eg Insurer Financial Strength)An issue rating reflects the likelihood of a specific issue to be paid by the Issuer on a timely basis, as well as some consideration of recovery prospectsIDR RR

IFS Rating

Fitch does not “approve”, certify or evaluate

Shar’iah compliance

Fitch’s Takaful Rating Methodology

> Takaful Rating Methodology Supplements existing Criteria for Conventional Insurers– “Non-Life Insurance Rating Criteria (Global)”, 2 March 2007– “Life Insurance Rating Criteria (Global)”, 2 March 2007– “Reinsurance Rating Criteria: Life and Non-Life (Global)”, 2 March 2007

> Fitch’s Methodology recognises that important differences do exist by country:– Attitude to Shariah compliant purchasing differs by region (Turkey, Malaysia,

UK, Dubai)– Legal and Regulatory Environment– Availability of Shariah Compliant Investments– Corporate Governance, Risk Management etc.

IFS Rating

IDR RR

Ratings Analysis in the Current Environment

> Application of ratings criteria in context of global recession and capital markets crisis

> Ratings criteria not changed – but focus and weighting of analysis adjusted– Liquidity– Idiosyncratic risks– Fixed income / Sukuk securities losses– Equity market scenarios– Leverage analysis– Earnings volatility– Diversification/complexity– Risk mitigants– Government support

AgendaFitch’s Analytical Process

Focus on Selected Takaful Issues

Ratings in the Financial Crisis

Simplified Diagram of a Generic Commercial Takaful Firm

> A. Availability of operator capital to Takaful fund participants

> B. Interest free loan (Qard al-Hasanah)> C. Priority of participants in the event of a winding up> D. Group rating methodology

Selected Important Issues

Shareholders of Takaful Operator

Takaful OperatorManages the Takaful Fund

Fund Participants

Takaful FundMutual Pool for the Collection of Contributions and the Payment

of Claims

Claims/ Distributions ContributionsDividends

Takaful Firm

Wakala Fee or Share of Profits Under Mudaraba

Qard al-Hasanah if Required

Source: Fitch

Affected by Legal,

Regulatory and Other Factors

A. Availability of Operator Capital to Takaful Fund ParticipantsThe Dilemma> 1. Segregation of Takaful operator and

Takaful fund is clear under Shariah principles– Takaful operator does not suffer

downside risk under Wakala or Mudarabah

But> 2. Availability of a Takaful operator’s assets

for the protection of participants is often critical for financial security

Depends on> Applicable laws & regulations> Wording of contracts and certificates> Memorandum and articles of association> Can participants rely on this capital in a

stress scenario?

Fees

Takaful Operator:Manages theTakaful Fund

Participants

Takaful FundMutual Pool for the

Collection of Contributions and the

Payment of Claims

Management Services

Qard al-Hasanah

B. Interest Free Loan (Qard al-Hasanah)

> Provided by Takaful operator to Takaful fund

> Mainly provides a short term financing function

> Much less important if participants have full recourse to Takaful Operator’s assets

Credit for existing loans> If meets Fitch’s hybrid criteria for

equity credit– Subordinated to policyholder interests– Restrictions on repayment (eg can only

be repaid from future surplus, no fixed maturity date)

– OR mandatory conversion to “equity” (ie donation)

Credit for future loans> Only if compulsory and suitable

triggers exist> Must also meet Fitch’s hybrid criteria

for credit

Fees

Takaful Operator:Manages theTakaful Fund

Participants

Takaful FundMutual Pool for the

Collection of Contributions and the

Payment of Claims

Management Services

Qard al-Hasanah

C. Priority of Participants in the Event of a Winding Up

> Example: Malaysia> Insurance Act 1996> 122.   (1)   In the winding up of an insurer,

the assets of an insurance fund shall be applied to meet its liabilities to policy owners and claimants under policies of that class of insurance business and these liabilities shall have priority over unsecured liabilities other than preferential debts specified under subsection 292 (1) of the companies Act 1965 to the extent that they are apportioned to the insurance fund.

> Not necessarily policyholder priority for Takaful firm

> No specific provisions in Takaful act 1984

Country Priority of policyholders?Australia Life Yes Non-life NoBarbados NoBermuda YesCanada YesCayman Islands NoFrance YesGermany YesIreland YesJapan Life Yes Non-life NoUnited Kingdom YesUnited States YesEuropean reinsurers NoUS reinsurers No

Description of Regulatory Environments(Select Jurisdictions Only)

Source: Fitch

D. Group Rating Methodology

> Having formed stand-alone view of financial strength – Assess potential group support based on– Ability to support

> 1. External barriers> 2. Financial strength

– Willingness to support> 1. Relationship with parent> 2. Support agreements

– Formal– Informal

> Fitch has internal guidelines to assess how much uplift to apply based on these elements

Holding Company

Sub-Holding Company

Asia Conventional

Insurer

Middle East Family Takaful

Retakaful

Middle East General Takaful

Asia Family Takaful

AgendaFitch’s Analytical Process

Focus on Selected Takaful Issues

Ratings in the Financial Crisis

Net Upgrades Less Downgrades

-25

-20-15

-10-5

05

1015

20

Q10

2Q

202

Q30

2Q

402

Q10

3Q

203

Q30

3Q

403

Q10

4Q

204

Q30

4Q

404

Q10

5Q

205

Q30

5Q

405

Q10

6Q

206

Q30

6Q

406

Q10

7Q

207

Q30

7Q

407

Q10

8Q

208

Q30

8Q

408

Q10

9

(No.)

Source: Fitch

Sliding Equity Markets

0

50

100

150

200

250

Jan 07 Jul 07 Dec 07 May 08 Oct 08 Mar 09

S&P 500 FTSE DAX CAC 40Italy Malaysia Egypt China

Source: Bloomberg/Yahoo finance

H208(31 Jan 07 = 100)

Yield on Government Securities Falls Sharply

0

1

2

3

4

5

6

Dec 07 Mar 08 Jun 08 Sep 08 Dec 08 Mar 09

Germany US UK ItalyFrance Spain Japan Malaysia

Source: Bloomberg, 5 year Generic Government Securities

H208(%)

Basis points 2 Jan 08 1 Jul 08 31 Dec 08 31 Mar 09AAA 6 +5 11 +49 60 +4 64AA 34 +24 58 +58 116 -13 103

A 46 +31 77 +45 122 +40 162

BBB 61 +69 130 +200 330 -35 295

BB 208 +105 313 +560 873 -138 735B 414 +165 579 +716 1,295 -304 991

Credit Spreads Increase Substantially

Source: Fitch RAPP

Takaful Developments…

The Takaful Industry has:> Avoided investing in Structured and Complex Products> Avoided providing Guarantees> Limited Investments in high profile failures (Lehman, AIG etc.)> Made Some Progress Towards a Clearer Regulatory

EnvironmentBut,> Losses from Equities> Credit losses expected to increase> Global downturn affects Takaful firms as well as Conventional

Insurers

Conclusion

> Takaful firms benefit from:– Absence of exposure to structured credit market, some other difficult assets– Absence of guarantees offered– Generally Low leverageBut:– Some Takaful firms hurt by high exposure to equity markets– Credit risk could also cause difficulties, especially where there are investment

concentrations

> Selected Developments– Challenging time for Insurers globally although important differences exist

between types of firm and specific organisations.– Some Progress Towards an Exposure Draft on Measuring the Solvency

Requirements of Takaful firms– Greater emphasis on some areas of rating process (investments, liquidity etc)

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