PERFORMANCE INCENTIVES IN THE TAKAFUL INDUSTRY:
AN EXPERIMENTAL INVESTIGATION

Abstract

The takaful industry offers customers insurance products judged to be compliant with Islamic law, in return for payments into insurance funds managed and invested by a takaful company henceforth called the ‘operator’. Contracts provide for a transfer of risk from policyholder to insurance fund, using a hybrid of two standard organisational forms: a) the stock insurance model, where the operator has control and ownership of residual funds, and b) the mutual insurance model, where policyholders enjoy control and ownership of residual funds. In the takaful industry, there is a complete separation of ownership of policyholder residual funds from their control, which rests solely with the operator. Policyholders are therefore in a classic principal-agent relationship with the operator, with obvious potential for agency costs. A case can therefore be made for regulation of the industry, to protect the interests of policyholders. One way to reduce agency costs is by appropriately designed monetary incentives to the operator. Policyholders are unable to act to control the operator’s compensation or decisions. A regulator is therefore essential to act on their behalf, as they are not represented and not properly taken account of by shareholders. Three forms of Shariah-compliant compensation, in order to study economic incentives for the operator to efficiently perform three broad categories of tasks, involving decisions on the size of the pool of policyholders, on cost control, and on investment of technical reserve. The three forms are sales commission (wakalah), sharing of investment profit (mudarabah), and sharing of residual funds (ji’alah). All three forms can be observed in practice, sometimes in concert, though in some regulatory jurisdictions some of them have been prohibited or restricted. The aim of the study is to provide empirical evidence on the efficiency and equity of the takaful organisational form. A laboratory experimental approach is chosen for the research design in order to avoid problems of non-availability and endogeneity of data. The experimental subjects were students from Durham University, incentivised in accordance with the research design through money payment. The data is analysed using Statistical software for data science (STATA). The implications of our findings for regulators show that only ji’alah offers an efficiency gain to the agency as a whole, the evidence in favour of including wakalah in a hybrid contract is weak. And there is no clear evidence of ‘gifts’ being reciprocated by better alignment of operator decisions with the welfare of policyholders.