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.