Risk Management In Islamic Financial Institution

Discussion

The main purpose of the assessment is to analyze the importance of risk management in a business organization. The assessment considers the business of Takaful companies and the various risks which are faced by the business. The assessment considers the risk management strategy of the business of Takaful companies. The main focus of the assessment is identification of risks, controlling and monitoring the risks which are faced by the business. In case of Islamic financial Institution, the risk management procedure can be slightly different from the conventional business as there is significant difference between Islamic and conventional financing. The study focuses on identifying the risks which are faced by Takaful companies and how the management deals and monitors such a risk in business.

Risk management in a business is considered to be an important area and the same is considered while making plans relating to future activities of the business. There are a variety of tools which are available to businesses and in case of Islamic financial institution the tools which are used are slightly different from conventional system. The first step is to identify the risks which are faced by the business of Takaful companies and then comes the management of such risks in business. The risks which are faced by the business are identified related two areas which are the operational area of the business which comprise of underwriting risks and operational risks and also investment area of the business which comprises of credit, liquidity and market risk. The different risks and its analysis is provided in the paragraphs below:

The underwriting risks in a business arises due to adverse selection of the applicants of the business. The selection of the adverse applicants of the business can result in losses for the company. In the case the applicants are high risks drivers and people with health problems would result in higher claim ratio for Takaful coverage and therefore such applicants can result in decline in the liquidity position of the business. These types of risks are known as re-takaful risks and they keep the company reliable for any claim from outside and provide financial protection on the basis of agreed terms. The main concerns for the business is that the risks can disturb the cash flows of the business and also the profit which is generated by the business and thereby poses a serious threat to the business.

Underwriting Risks

The operational risks of the business are related to the general expenses of the business and the same is related to the lack of appropriate internal control of the business. The operational risks of the business are mostly related to internal business circumstances but in some cases such risks can also arise from external sources as well. The internal crisis arises due to ineffective internal control system and also due to non-compliance of regulations. Some other areas which can affect the business and can lead to riskiness is the employee who are working in the organization. The employee level of efficiency and skills plays a vital factor in the performance of the business. In case of any incompetence’s of the employees, the operational structure would be hampered and thereby entire performance of the business would be affected. In addition to this, the cash management policy of the business is also an important aspect of the business and faces the maximum risks of the business. All the other risks might lead to financial loss for the business and also reputational damage of the business.

The credit risk of a business reflects the inability of the clients to effectively meet the financial obligations of the credit and as per the agreed terms. Takaful industry is engaged in insurance business and therefore is also exposed to lot of risks which in this case can be treated as following:

• Default risks: There is a risk of default from the part of client for which Takaful operators receives part of the cash flow or assets as the applicant is unable to meet the financial obligations which was agreed upon.
• Migration risks: This risk reflects when a chance of future default by applicant has the capability of influencing the contract of today.
• Spread risks: This risk happens mainly because of increased risk for macro and micro reasons.
• Concentration risks: This risk is common when a lot of same business operates in a certain area and thus there is lot of concentration of businesses in area which leads to increase in the competition which is risky for businesses.

The liquidity risks of a business affect the ability of the business to meet the current obligations of the business and the same is quite high in case of Insurance Company. The insurances are affected by investment risks, capital fund risks. The capital fund risks cannot outsource funds when the same.

The risks which are related to the market are known as market risks. The market risks are mostly related to fluctuation in prices of the business and also the other factors which can affect the instruments of Takaful company. The four types of Market risks which can be identified are:

• The risk of fluctuation in prices of equity instruments falls under the purview of market risks of the business.
• Currency risks relates to the fluctuation in currency and foreign exchange of the businesss.
• Interest rate risks are common for insurance companies and the same related to the fluctuation in exchange rate of the market.

This refers to the risks of intervention of the regulations which are established by the government. It also includes risk of non-compliance within any stage of the takaful product offered to the business.

The mitigation of the risks of the business is the responsibility of the management of Takaful company but it is imperative that the management needs to identify the risks of the business. The management needs to formulate strategy for the purpose of identifying and mitigating the risks of the business. The follow risk management plan for different types of risks are given below:

• The companies’ objectives should be clearly stated out signifying all the needs and standard procedures.
• Takaful needs to formulate strategies for the purpose of diversifying the risks of the business.
• The management needs to make the entire process in computerized environment so that participants with high claim possible are automatically rejected

• The policies should be formulated by the board of directors so that the operational risks of the business are minimum.
• The management needs to establish quality control department so that proper training is provided to the employees and scope for mistakes is reduced.
• Secure reporting system must be set by using professional auditors as they point out flaws in internal processes of the company.

The management of credit risks for Takaful companies is bit of a challenge as no such tools exist which can help the business to effectively manage the risks of the business. Derivatives are interest-based instruments which are prohibited by Shariaa, Takaful companies need to innovate Islamic derivatives that can be used as tools for risk management.

The liquidity risks of the business can be monitored and managed with the help of cash flow modelling approaches and also with the help of liquidity ratios. Takaful companies need to effectively manage the surplus and deficits of the business. The management needs to manage the liquid assets and liabilities of the business in case of considering the liquidity approach of the business. Capital funding risk as part of liquidity risk, also need to be mitigated, through liquidity hedging strategy, planning re-takaful policies, knowing current level of liquid assets in hand, adopt adequate internal control and proper disclosure of information in the organization.

As instruments based on interest rates are not Shariaa compliant, ways of managing market risk in Takaful is different than those in conventional insurance companies. The general instrument of futures, forward and swap cannot be used in Islamic Financial Instruments. Cooperative hedging and bi-lateral mutual adjustment are the alternative options which are available to Takaful companies to mitigate currency and interest rate risk. The stress test and Value at Risks (VAR) are used for mitigation of commodity price risk and equity risks.

Takaful companies needs to stay up to date with the regulations which are brought about by the government and also consider any amendments which are made in the same. Also, it should be reviewed by Shariaa board to make sure it doesn’t conflict with Shariaa rules and at any stage.

Conclusion

Takaful is a unique insurance instrument for Islamic finance which is appropriately shown in the discussion above. The different risks which are faced by such companies are also established in the discussion part along with mitigation measures for each type of risks of the business. The risk management process needs to be given focus in order to make the business more efficient in nature. The risk management process should also be updated on the basis of changes which are occurring in the market.

Reference

https://mpra.ub.uni-muenchen.de/40005/2/Research_paper_Risk_Mgt.pdf

https://ifsb.org/standard/2013-12-16_eng_IFSB14%20Risk%20Management%20for%20%C4%81ful%20Undertakings_(Dec%202013).pdf