Optimal incentives for takaful (Islamic insurance) operators

• This paper analyses the optimality of incentives offered to takaful operators.
• Takaful operators should always be offered a share in the insurance surplus.
• Wakalah (agency fee) induces the agent to increase the size of the pie and should be offered.
• Offering mudarabah (a share in investment income from technical reserves) with surplus-sharing may not always be optimal.

The relationship between policyholders and an Islamic insurance (takaful) operator is in essence a principal-agent relationship. This paper analyzes the power of incentives offered to takaful operators in mitigating problems associated with such a relationship. These incentives include wakalah, an upfront agency fee as a percentage of premiums; mudarabah, a share in investment income from technical reserves; and surplus-sharing (a share in the insurance surplus). The paper concludes that all incentives offered to takaful operators must include surplus-sharing and that offering mudarabah in the presence of surplus-sharing is optimal only when the risk-adjusted return on investing technical reserves outweighs a similar return on effort exerted in underwriting risks. A wakalah hybrid is also recommended as it induces the operator to increase the size of the pool that, in turn, reduces average risk to the benefit of policyholders.