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Challenges on the way to better rating for Takaful companies
February, 2016

Should convincing ratings analysts be so difficult, questions Muhammad Ashraf Ali.

Looking at the long list of requirements of the rating agency I never thought the Alphabet would be so important even after leaving school and made me feel as if I was preparing a college assignment to secure ‘A+’ in the term though the latter was much easier to do than the former. To be honest I found convincing rating analysts as difficult as pleasing a tough professor who believes giving away an ‘A’ would raise doubts about his own credentials.

What makes attaining a good rating so important for insurance companies? Why go through all this pain of visiting haunting memories of the past? The answer lies in the very nature of our business – words are my trade; as it were. Insurers sell promises of a secured future and to add credibility to that promise present their financials but to gauge true strength from those financials is not easy for all as they show past strength whereas the need for the fulfillment of that promise always arise in the future. This gives reason to the existence of the rating agencies as they base their independent opinion on current financial situation as well as future plans and trends.

This need of having a strong rating is common to both insurance and Takaful companies as the fundamental strength indicators are common although the Takaful companies and the overall Takaful market in Qatar are comparatively smaller.  The future holds tremendous potential for Takaful operators in Qatar as the government spending on infrastructure projects is on the rise that has also created an influx of labour coming in to Qatar, thus expanding the market base for insurance and Takaful companies on both life and non-life sides. These opportunities come with equal share of challenges and securing good IFS rating, preferably an ‘A’, is top of the list.

It would be interesting to mention that no Takaful Company in the region, including Qatar, is in the prestigious ‘A’ club of any rating agency. Why is that so? Well, if you go through the rating report you find some interesting commentary on strengths, offsetting factors, positive and negative pressures. The overall commentary may be different in reports by various rating agencies for the same company but the rating factors taken into consideration are more or less the same as shown in the exhibit 1 below:

Rating agencies have identified what is lacking in all these areas in Takaful companies operating in the region including Qatar and have suggested how Takaful companies can develop these areas to move forward to a better rating – a much desired  ‘A’ to be specific. A critical analysis of these reminds me of an old saying - It’s easier said than done. The suggested way is quite challenging and has significant implications on the overall business. This puts the management in a dilemma to balance short terms and long term objectives and profitability.

The most common of them all is the suggestion to diversify into other areas of investment in order to reduce “Investment risk” created by concentration of investment in Real Estate and Equity enhancing thereby the balance sheet strength. This situation is common to both Takaful companies and their conventional counterparts but the former has very limited option to act upon this suggestion. Takaful companies cannot invest in interest bearing instruments and even have to make a selection in the equity market as well. This shortage of permitted investment avenues has made the investment portfolio of Takaful companies extra weighted towards real estate in particular.

Even the next best option of “sukuk” are being issued in very limited number in the region let alone the State of Qatar as compared to other regions like Pakistan and Malaysia. Besides this the rate of return on sukuk is very low as compared to the yields being generated in stock and real estate markets in Qatar as shown in the exhibit 2 below:

Furthermore Sukuks are presented as an option based on the argument that in case of a downturn in the real estate market the investment may not be easily turned liquid thus exposing the company to a liquidity crunch. Well the same holds equally good for sukuks even without a downturn due to non-availability of the secondary markets. Well the most liquid one are COI’s of Islamic banks but the return on them in Qatar is minuscule as shown above. It is also well established that the technical profits of the insurers including Takaful operators are getting thinner, if any company was posting such, due to intense competition – therefore moving away from Real Estate and Equity market will put further pressure on overall earnings.

It may also be argued that the concern on being illiquid or the risk of selling at a throw away price during a downturn in the Real Estate market is not completely true as most of the companies have booked the real estate on book value which acts as an automatic cushion in case of a downturn in the market and yields positive results adding to the balance sheet strength even if sold during crisis.

The second most common suggestion is to diversify portfolio to minimise concentration on high risk motor & engineering, (yes, one rating agency has termed engineering high risk), due to underdeveloped product offering. If we look at the region in general and Qatar in particular, what we all see is fleets of all types of cars and an unending series of development projects. We all know the average household in Qatar has more than one car and the country is spending more than USD200 billion on infrastructure alone (malls, residential and commercial towers not included). So if Takaful companies in Qatar do not underwrite motor and projects, what else should they underwrite in the current economic environment?

It is also suggested to diversify geographically to minimise the “concentration risk,” yet another, created due to all business being written in one territory/country i.e. State of Qatar. Sounds every good but there’s one small problem in following this advice. As mentioned above it is generally agreed that the competition is intense in the market at national, regional and global level. Imagine what the competition would look like if all Takaful companies expand even regionally only and each open office in each other’s domicile? Qatar is a small country but already has 26 companies including eight Takaful providers – the competition is not only with Takaful companies but with conventional companies as well. So ideally if the advice is followed by all players in the region all will end up cutting each other’s throats!

Lack of ERM is also put forward as a factor creating downward pressure on the rating. Takaful companies in Qatar write simple traditional products with minimal complexity therefore sophisticated ERM and Capital models are logically deemed not necessarily required. Furthermore the underwriting leverage of Takaful companies in Qatar is already on a lower side keeping them adequately capitalised. So what utility would capital modelling add?

Last but not the least, the strength of Regulation is considered by rating agencies as an important component in assessing the financial strength of Takaful companies. There is a lack of specific regulation for Takaful in QFC (regulation being part of the one set of regulations for all) and it is non-existent outside QFC in Qatar. This is something beyond the control of the Takaful companies but it would be interesting to note that the operating performance of the companies outside QFC is believed to be better than the ones operating under QFC (one listed Takaful company being declaring both shareholder’s dividends and policyholders’ surplus incessantly for many years whilst same is unheard of by any QFC company so far or at least is not known).

There’s no denying the fact that these suggested improvements are made in right earnest and have logic too but in the current operating environment in MENA including Qatar they pose another question to the management and the boards – what do we want most? Good rating or returns? Unfortunately the answer is never straightforward as it seems to be the chicken and egg dilemma from an insurance or for that matter Takaful perspective.

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