A HANDBOOK FOR

ASSOCIATE QUALIFICATION
IN ISLAMIC FINANCE

ISLAMIC BANKING & FINANCE INSTITUTE MALAYSIA

Recommended learning material for

ISLAMIC FINANCE ARCHITECTURE
 First Published by
IBFIM 200701005076 (763075-W)
3rd Floor, Menara Takaful Malaysia, Jalan Sultan Sulaiman, 50000 Kuala Lumpur, Malaysia
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First Edition 2016

©IBFIM 2016
Revised Edition 2020

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CON TENTS

PAGE

TOPIC 1
OVERVIEW OF ISLAMIC FINANCE INDUSTRY 1-5

TOPIC 2
ISLAMIC FINANCE ARCHITECTURE : ISLAMIC BANKING 6-18

TOPIC 3
ISLAMIC FINANCE ARCHITECTURE : TAKAFUL 19-34

TOPIC 4
ISLAMIC FINANCE ARCHITECTURE : ISLAMIC CAPITAL MARKET 35-46

TOPIC 5
ISLAMIC FINANCE ARCHITECTURE : ISLAMIC WEALTH MANAGEMENT 47-59

GLOSSARY 60-61
Topic 1
Overview of Islamic Finance Industry

Learning Objectives
At the end of this topic, you will be able to:
• Understand the pillars of Islamic financial system
• Explain the Shariah values that are consistent with universal values
• Describe Islamic finance industry globally

UNIT 1: PILLARS OF ISLAMIC FINANCE

Islamic finance is a comprehensive financial system that adheres to Islamic principle and it refers to financial
market transactions, operations and services that comply with Islamic rules, principles and codes of practices.
Islamic finance was practiced predominantly in the Muslim world throughout the Middle Ages, fostering
trade and business activities. In Spain and the Mediterranean and Baltic States, Islamic merchants became
indispensable middlemen for trading activities.

Islamic Financial System

Materiality, Sanc�ty of
Fairness/ No Economic Contracts
Exploita�on Purposes
No Financing
Risk Prohibi�on of of Ac�vi�es
Sharing Interest (Riba) prohibited by
Islam

Diagram 1: Pillars of Islamic Financial System

The foundation of Islamic financial system is supported by six important pillars, as illustrated in Diagram 1,
and they are:

1. Fairness/No Exploitation
Islam promotes fairness and no exploitation in business transaction. Therefore, the state, condition, or
quality of the business must be fair and free from bias or injustice.

2. Risk Sharing
One of the main features of the Islamic finance model is that it is based on a profit-sharing principle,
whereby the risk is shared by the bank and the customer. This system of financial intermediation will
contribute to a more equitable distribution of income and wealth.

3. Materiality, Economic Purposes

Islamic financial system is developed to fulfil the materiality and economic purposes, as it is relating to
the necessities of humans’ life. Although it is based on Shariah principles to meet the financial needs of
Muslims, it is not restricted to Muslims only and is also available to non-Muslims as well.

Topic 1 Overview of Islamic Finance Industry 1

 4. Prohibition of Interest (Riba)
Riba has been strictly prohibited by Islam. The Shariah wishes to eliminate not merely the exploitation
that is intrinsic in the institution of riba, but also that which is inherent in all forms of unjust exchange in
business transactions.

5. Sanctity of Contracts
Sanctity of contract refers to the principle that the parties to a contract, having duly entered into the
contract, must honour their obligations under it. Islam does emphasize on the sanctity of contract as it
gives recognition to the contractual framework with appropriate legislation in business transactions.

6. No Financing of Activities Prohibited by Islam

Consistent with the principles of Shariah and its practical application through the development of Islamic
economics, Islamic financial system does prohibits all financing that are haram in Islam, since the objective
of Shariah is to protect human beings from harm. Activities that involve gambling are prohibited by Islam
since gambling are proven to be one of the social disease that could destroy the community.

The traditional values of Islamic finance are growing in appeal for Western investors due to its strict ethical
principles, strong performance and resilience, Islamic finance is now considered a potential alternative to
conventional finance. Furthermore, Shariah values are consistent with universal values which are real
activities, ethical, partnership and governance. All of these values are summarized in Diagram 2.

Real Ac�vi�es Ethical

• Direct link to real economy • Avoidance of unethical ac�vi�es such as hoarding

• Certainty – supported by underlying ac�vi�es • Avoidance of gambling (maysir) and interest (riba);
(avoidance of gharar or uncertainty) and also non-permissible goods and services
• Prohibits excessive leveraging • Screening investment
• Forbearance for customers in difficul�es

Governance Partnership

• Greater transparency and disclosure due to • Different contractual rela�onship

addi�onal Shariah governance and unique risks • Equity-based and risk-sharing transac�ons
• Greater fiduciary du�es and accountabili�es • Clearly defined risk and profit-sharing
• Emphasize on clear documenta�on and contract characteris�c serve as addi�onal built-in
add to soundness and stability mechanisms

Diagram 2: Shariah Values that are Consistent with Universal Values

2 Topic 1 Overview of Islamic Finance Industry

The Islamic finance industry must be comprehensive with all critical components established as to ensure
stability and longevity as to compete with the existing conventional finance industry. Islamic finance consists
of four main components which are Islamic banking, takaful, Islamic capital market and Islamic wealth
management.

Diagram 3: Components of Islamic Finance

Topic 1 Overview of Islamic Finance Industry 3

 UNIT 2: OVERVIEW OF GLOBAL ISLAMIC FINANCE
The Islamic finance industry covers three main sectors, namely banking, capital market, and Takaful. The
Islamic financial industry's size is always measured based on the real assets owned by the institutions that
are considered part of the Islamic financial sector.

According to the President of the Association of Islamic Banking Institutions Malaysia (AIBIM), Datuk
Adissadikin Ali (2018), the size of the Islamic financial industry is expected to reach total global assets of US$
3.8 trillion by 2022.

The Islamic Financial Services Board (IFSB) in its Annual Stability Report 2020 stated that the total worth of
Islamic Financial Services Industry (IFSI) has increased to an estimated USD 2.44 trillion in 2019 (from USD
2.19 trillion in 2018).

Region Banking Sukuk Islamic Funds’ Takaful Total Share

Assets Outstanding Assets Contribu�ons
GCC 854.0 204.5 36.4 11.70 1,106.6 45.4%

South-East Asia 240.5 303.3 26.7 3.02 573.5 23.5%

Middle East & South Asia 584.3 19.1 16.5 11.36 631.3 25.9%
Africa 33.9 1.8 1.6 0.55 37.9 1.6%

Others 53.1 14.7 21.1 0.44 89.3 3.7%

Total 1,765.8 543.4 102.3 27.07 2,438.6 100%
Share 72.4% 22.3% 4.2% 1.1% 100%
*Data for Sukuk outstanding and Islamic funds are for full-year 2019; for Islamic banking, they are as at 3Q19; and for takaful, they are as at end-2018

Table 1: Breakdown of the Global IFSI by Segment and Region (USD billion,2019)

To date, Islamic finance has made inroads into Africa through the existence of Islamic banking and takaful
firms. Islamic finance has expanded its presence in Europe mainly via capital markets. Islamic funds continued
to expand in the region, while Sukuk listings by foreign issuers on the European Exchanges are also on the
rise. The growth will be mainly contributed by leading key markets of Malaysia, Saudi Arabia, the UAE, Qatar
and Kuwait; new domiciles such as Indonesia and Turkey; as well as the expected debut markets in Africa
and Central Asia.

Despite various claims by non-Muslim governments of being global or regional centres of excellence for
Islamic finance, the OIC countries remain leaders in terms of incidence of Islamic financial assets. In a list
of top 20 countries in terms of Islamic financial assets, the UK is the only non-Muslim country that features
significantly. The USA and European countries other than the UK have yet to receive attention and confidence
of Islamic investors.

Furthermore, despite attempts by European financial centres to attract business and investors from Islamic
asset managers, Saudi Arabia tops the list of domicile of Islamic funds in terms of assets under management
(AUM). Malaysia has for some time invested considerable amount of resources into Labuan to develop
it as a jurisdiction of preferred choice for Islamic capital markets transactions and wealth management.
Furthermore, Western (e.g., BNP Paribas) and other financial institutions (e.g., Nomura) based in Kuala
Lumpur are performing far better in their Islamic businesses than their counterparts based in Europe.

4 Topic 1 Overview of Islamic Finance Industry

 PRACTICE QUESTIONS

1. Islamic financial system refers to financial market transactions, operations and service that comply with
Islamic rules, principles and codes of practices. Which of the following are NOT the components of the
Islamic finance.

A. Islamic banking

B. Takaful

C. Islamic Capital Market

D. None of the above

Topic 1 Overview of Islamic Finance Industry 5

 Topic 2
Islamic Finance Architecture: Islamic Banking

Learning Objectives
At the end of this topic, you will be able to:
• Explain Islamic banking system
• Describe the evolution and innovation of Islamic banking products and services
• Discuss the issues and challenges related to Islamic banking

UNIT 1: INTRODUCTION TO ISLAMIC BANKING

Islamic banking is a system of banking or banking activity that is constant with the principles of the Shariah
(Islamic rulings) and its practical application through the development of Islamic economics. It emphasizes
moral and ethical values in all dealings and has wide universal appeal.

Islamic banking has emerged as an important financial system with worldwide acceptance, as it offers a
wide range of products and facilities to accommodate user’s needs. The hallmark of Islamic banking is its
prohibition of the interest rate (riba) on money capital (lending and accepting of money) and carrying out
trade and other activities that provide goods or services considered contrary to the principles of Shariah.
These principles are not new but arguably, their original state has been altered over the centuries. The
principle source of Shariah is the Quran followed by the recorded sayings and actions of Prophet Muhammad
SAW, known as the Hadith.

While these principles were used as the basis for a flourishing economy in earlier times, it is only in the
late 20th century that a number of Islamic banks were formed to provide an alternative basis to Muslims
although Islamic banking is not restricted to Muslims. Islamic banking operates in accordance with the rules
of Shariah, known as Fiqh al-Muamalat. Practices must be consistent with the Shariah and its practical
application through the development of Islamic economics. Many of these principles upon which Islamic
banking is based are commonly accepted all over the world, for centuries rather than decades.

The modern Islamic bank can be traced back to the very birth of Islam when the Prophet SAW himself used to
trade for Khadijah (R.A) on the basis of Mudarabah prior to Islam. Mudarabah dominated the business world
for centuries and the concept of interest found very little application in day-to-day transactions.

Such partnerships performed an important economic function. They combined the three most important
factors of production, namely: capital, labour and entrepreneurship, the latter two functions usually
combined in one person. The capital-owner contributed the money and the partner managed the business.
Each shared in a pre-determined share of the profits. If there was a loss, the capital-provider lost his money
and the manager lost his time and labour.

The Islamic banking is a unique arrangement which does not only promote stability in the system but also
aim to achieve justice to all segment of community. To achieve such aims, Islamic banking system is based on
the principle that abundant wealth has to be distributed in equitable and efficient manner.

Islamic banking has generated much interest in the local and international scenario. The positive growth and
developments in Islamic financial system have brought forth new and expanded opportunities although it is
considered as a new phenomenon in banking industry throughout the world. Today, the Islamic finance is
the fastest growing component in the financial services industry, with an annual growth rate in between 20
to 25 percent over the past decade. It is estimated at least 70 countries throughout the world have some or
other form of Islamic financial services available in their country.
6 Topic 2 Islamic Finance Architecture: Islamic Banking
 It is notable to note that almost all major multinational banks such as UBS, Citigroup, HSBC, ABN Amro,
BNP Paribas, Credit Agricole, Standard Chartered, and other international banks are offering Islamic finance
services either in retail, corporate or at investment banking level. The market for Islamic financial instruments
is continuously flourishing. In fact, there are over 300 Islamic financial institutions worldwide across 75
countries. According to the Asian Banker Research Group, The World's 100 largest Islamic banks have set an
annual asset growth rate of 26.7%2 and the global Islamic Finance industry is experiencing average growth
of 15-20% annually.

In terms of banking acceptance, the Islamic banking market share has dominated the markets in Iran and
Saudi Arabia, as shown in Diagram 4 below:
600 100%

90%
500
80%

70%
400
60%
USD bilion

300 50%

40%
200
30%

100 20%

10%
0 0
Iran*
Saudi Arabia
Malaysia
UAE
Kuwait
Qatar
Turkey
Bangladesh

Jordan

Eqypt

Kenya
Sri Lanka
South Africa
Indonesia
Bahrain
Pakistan

Sudan
Oman

Brunei
Iraq
UK*
Algeria
Pales�ne
Tunisia

Bosnia & Herzegovina

Thailand*
Lebanon

Senegal

Afghanistan
Nigeria
Maldives
Djibou�

Tanzania
Kazakhstan
Kyrgyz Republic*
Mauri�us*
Islamic Banking Assets 3Q19 (LHS) 3Q19 Market Share
* Where 3Q19 data were not available, the latest available figures were used.
Source: PSIFIs IFSB Secretariat Workings

Diagram 4: Islamic Banking Assets and Market Share (3Q19)

Based on Diagram 4 above, the majority of countries made significant Islamic banking market-share gains
relative to conventional banking in 3Q19. A notable example in this regard is Saudi Arabia, which attained
a 69.0% (2Q18: 52%) Islamic banking market share due to (among other reasons) higher penetration
of the Islamic banking windows and a supportive regulatory environment that aligns with the economy
diversification vision of the Saudi Arabia government.

In terms of the top jurisdictions for Islamic banking assets, Iran at 28.6% (2Q18:32.1%), Saudi Arabia 24.9%
(2Q18:25.1%), Malaysia 11.1% (2Q18: 10.8%), UAE 8.7% (2Q18: 9.8%) and Kuwait, which remains at 6.3%,
are the top five. The other countries in the top 10 Islamic banking jurisdictions, in order of size, are Qatar,
Turkey, Bangladesh, Indonesia and Bahrain as shown in Diagram 5.

Topic 2 Islamic Finance Architecture: Islamic Banking 7

 Pakistan 1.1% Egypt 0.8%
Sudan 0.6% Jordan 0.7%
Bahrain 1.8% Oman 0.7%
Indonesia 2.0% Brunei 0.4%
Others 1.6%
Bangladesh 2.1%
Turkey 2.6% Iran 28.6%

Qatar 6.1%
Kuwait 6.3%

Malaysia
11.1%
UAE Saudi Arabia
8.7% 24.9%

*The share is apportioned in US dollar terms.

Source: IFSB Secretariat Workings
Diagram 5: Share of Global Islamic Banking Assets (%) (3Q19)

2,000
1,800 GCC
1,600
Southeast Asia
1,400
USD bilion

1,200 Middle East and South Asia

1,000 Africa
800
Others
600
400
200
0
2018 2019 2019F Source: PSIFIs, IFSB Secretariat Working

Diagram 6: Islamic Banking Assets (2018-2019F)

Overall, global Islamic banking assets have increased significantly even though the growth is relatively slow
due to economic factors such as the depreciation of local currencies that affect Islamic banking assets' value.
However, this market can still increase the asset values from USD 2 trillion for the first time in 2017 to USD
2.44 trillion in 2019. The industry has also been booming in the domestic stock market, particularly in the
Islamic banking sector in 20 countries.

8 Topic 2 Islamic Finance Architecture: Islamic Banking

 UNIT 2: ISLAMIC BANKING EVOLUTION
The birth of Islamic bank begins when the Islamic scholars from various backgrounds had sit together as to
discuss the establishment of one banking system that is free from suppression and discrimination.

In general, the growth of Islamic banking can be divided into two distinctive periods. The first period or the
early stage experiment in Islamic banking took place in most cases on individual initiatives with government
playing a more or less passive role. The early experiments with Islamic banking took place in Malaysia in
the mid 1960’s, Pakistan in the late 1950’s, via the Indian Jama’at Islami in 1969, Egypt’s Mit Ghamr Savings
Bank (1936-67), and the Naseer Social Bank (1971). Most of these institutions were established and operated
based on social or rural orientation. Most of the early experiments were unsuccessful except for Naseer
Social Bank (Egypt) and Tabung Haji (Malaysia) for several reasons.

The second stage of the growth of Islamic banking has been significantly helped by the encouragement
provided by the governments of a number of Muslim countries. The establishment of Islamic banks in a
number of countries has been facilitated by special enactments and suitable changes in banking legislation
and infrastructure. This new change in the political climate in many Muslim countries was induced by the
energy price rise in 1973-74, which increases the Arab oil wealth. The oil resources enabled a wide range
of institutions to participate in the social and economic development of Muslim countries, while facilitating
resurgence in self-confidence in the Middle East. Almost significant event that also influenced the country-
wide establishment of Islamic banks is the Third Islamic Conference of Foreign Ministers, held in Jeddah in
1972, when a programme to abolish interest from Islamic financial institutions was presented by the finance
ministers of 18 participating countries. A comprehensive plan to reform the monetary and financial systems
of the Islamic communities according to Shariah was laid out concurrently.

One of the important outcomes of the conference held in Jeddah, was many Muslim countries started to
show their commitment by initiating various effort in order to ‘Islamise’ their financial system especially
with regards to Islamic banking practices. Generally, the process of ‘Islamisation’ that has taken place in the
Muslim countries can be divided into two different approaches or settings. This approach is aimed at economy
wide elimination of interest. The country that pioneered the full Islamisation process were Pakistan, Iran and
Sudan. The second approach taken by other Muslim countries was the promotion and adoption of Islamic
banking practices alongside conventional banking. In other words, the existence of individual Islamic banks
side by side with interest based banks. For example, Malaysia has adopted such setting whereby individual
Islamic banks co-exist with conventional banks.

2000’s • Interna�onal Islamic Financial Market (IIFM), Bahrain

• Islamic Banking Finance Ins�tute Malaysia (IBFIM), Malaysia
• Malaysia Interna�onal Islamic Financial Centre (MIFC), Malaysia
• Islamic Financial Service Board (IFSB), Malaysia
• Interna�onal Centre Educa�on for Islamic Finance (INCEIF), Malaysia
• Bursa Suq al-Sila’ (BSAS)/ Bursa Komodi�, Malaysia
• Associa�on Shariah Advisors in Islamic Finance (ASAS), Malaysia
• Chartered Ins�tute of Islamic Finance (CIIF), Malaysia
• Shariah Leaders Educa�on Programme (SLE), Malaysia
• Associa�on Islamic Banking Ins�tute Malaysia (AIBIM)
• Interna�onal Shariah Research Academy for Islamic Finance (ISRA)

1990’s • Islamic Bank of Brunei, Brunei

• Islamic Interbank Money Market, Malaysia
• Accoun�ng and Audi�ng Organiza�on for Islamic Financial Ins�tu�ons (AAOIFI), Bahrain
• Bank Muamalat Malaysia Berhad, Malaysia

1980’s • Al-Baraka, Egypt

• Bank Islam Malaysia Berhad, Malaysia Topic 2 Islamic Finance Architecture: Islamic Banking 9
• Islamic Bank, Bangladesh
 • Accoun�ng and Audi�ng Organiza�on for Islamic Financial Ins�tu�ons (AAOIFI), Bahrain
• Bank Muamalat Malaysia Berhad, Malaysia

1980’s • Al-Baraka, Egypt

• Bank Islam Malaysia Berhad, Malaysia
• Islamic Bank, Bangladesh
• Qatar Islamic Bank, Qatar
• Dar Al Mal Al Islamic Trust, Switzerland
• AHZ Global Islamic Finance, UK

1970’s • Nasser Social Bank, Egypt

• Islamic Development Bank, Jeddah
• Dubai Islamic Bank, Dubai
• Faisal Islamic Bank, Sudan
• Bahrain Islamic Bank, Bahrain
• Al-Amanah Islamic Bank, Philipines

1960’s • Mit Ghammr, Eqypt

• Lembaga Tabung Haji, Malaysia

Diagram 7: Development of Islamic Banks from 1960’s till 2000’s

Models of Islamic Banking

The development of Islamic banking is a worldwide occurrence. But, each jurisdiction adopts varying
approaches to develop the Islamic banking system. It would not be fair to determine which approach and
model would be effective. However, success of such a model would be contingent on how IFIs are nurtured
and supervised.

There are two approaches or models in implementation Islamic banking system; namely, (1) standalone
Islamic banking system only (Islamising the country’s financial system), (2) operates a dual banking system
where the Islamic banking system operates in parallel with the conventional system. Most of the countries
in the world choose Category 2 as their approach in the implementation of Islamic banking system. In such a
dual system, it is necessary to avoid the potential for regulatory arbitrage that may result in distortions that
undermine the environment of a level playing field between conventional finance and Islamic finance.

NO Category Countries
1. Islamic banking system only Iran, Sudan
2. Dual system, whereby Islamic banking system e.g. Malaysia, Kingdom of
opera�ng in parallel with the conven�onal SaudiArabia, Indonesia,
system Bahrain, Pakistan, etc.
Table 2: Approach in Implementation of Islamic Banking System

For instance, in Malaysia, the Islamic financial system operates in parallel with the conventional financial
system, as per Diagram 8 below:
Conventional Financial System Islamic Financial System
Conventional banks Islamic banks • Leveraging on operating infrastructure
of conventional banks.
Islamic windows • Level playing field.
Conventional banks • Minimize regulatory arbitrage.
Islamic subsidiaries • Comprehensive components of IFIs
important to facilitate an effective
Conventional money market Islamic money market intermediation process.

Conventional capital market Islamic capital market

Insurance companies Takaful operators

Source: Bank Negara Malaysia

Diagram 8: Islamic Financial System in Parallel with Conventional System

10 Topic 2 Islamic Finance Architecture: Islamic Banking

In dual banking systems, subject to the regulation, the governance structure of Islamic banking can be
identified as follows:

Model 1 : Full-fledged Islamic banks either newly licenced or converted

from conven�onal banks

Model 2 : Islamic banking windows of conven�onal banks

Model 3 : Islamic banking subsidiaries of conven�onal banks either

newly established or converted from exis�ng Islamic windows

Diagram 9: Models of Governance Structures Practiced in Islamic Banking

For Islamic banking windows and subsidiaries, the overriding regulatory concern has been the prevention of
any mixing of Shariah-compliant and non-compliant funds. Therefore, such windows and subsidiaries have to
comply with firewall requirements, including separate capitals for the two types of banking services.

Topic 2 Islamic Finance Architecture: Islamic Banking 11

 UNIT 3: PRODUCT INNOVATION IN ISLAMIC BANKING
Islamic banking institutions operate in a very competitive and demanding industry. In order to stay relevant,
they must be able to meet their customers' sophisticated financial needs. Product innovation is seen as the
key success to maintain current business growth. Interestingly, the development of new products happens
more extensively in the banking institutions of South East Asia when compared to innovation within the
Middle East. For instance, Malaysia is one of the countries where new products are regularly developed.
The country became the first to establish the Islamic Inter-Bank Money Market (IIMM), the full-fledged
Islamic stock broking company, the corporate sukuk (Islamic bond) and the Islamic unit trust. Therefore,
product innovation is a significant area in which Islamic banking and financial institutions should focus their
resources. Table 3 illustrates products and services offered by Islamic banks:
Corporate Investment
Consumer Banking Business Banking Treasury Others
Banking
• Personal Financing • Current Accounts • Corporate Banking • Corporate deposit • Cash Management
• Vehicle Financing • Term Deposit • Corporate Finance & placements • Wealth Management
• Home and Fixed Asset • Business Financing Advisory • Foreign Exchange
Financing • Cashline • Debt & Islamic Capital • Structured Product
• Savings Accounts • Leasing & Hire Purchase Markets
• Current Accounts • Trade Finance and • Syndica�on
• Term Deposit Services
• Credit Card • Bridging Finance
• Debit Card • Equity Financings
• Investment Account

Table 3: Products and Services Offered by Islamic Banks

Approaches for Developing Islamic Banking Products and Services

In order to develop new Islamic banking products that are competitive in the market, two approaches that
are always being considered by the Islamic scholars are replication and innovation. Both approaches are able
to drive the productivity and performance of the business, and helps Islamic banks to grow and improve.

1. Replication
In business, replication is always being associated with observations made under identical conditions, or
duplication or reproduction of a test result at another location or time. Technically, there is no harm in
replicating conventional products unless there are prohibited elements involved. However, replication
strategy is not suitable for the growth and development of Islamic finance industry in the long term.
Replication affects the essence of creativity and innovation, and will serve the same economic benefit
of conventional products, but in the long run, we will need definitely needs further improvement on the
process of innovation.

2. Innovation
Innovation refers to the process of translating an idea or invention into a good or service that creates value
or for which customers will pay. To be called an innovation, an idea must be replicable at an economical cost
and must satisfy a specific need. Innovation involves deliberate application of information, imagination
and initiative in deriving greater or different values from resources, and includes all processes by which
new ideas are generated and converted into useful products. In business, innovation often results when
ideas are applied by the company in order to further satisfy the needs and expectations of the customers.

Innovation may potentially result in creating instability, but it is desirable if this creates some economic
value benefiting the society. In fact, the establishment of Islamic finance industry can itself be considered
as an innovation. The global acceptance of Islamic finance and its consideration as an alternative system

12 Topic 2 Islamic Finance Architecture: Islamic Banking

for solving global economic crisis has raised the bar. Therefore, industry experts should think beyond
replication. Some of the Islamic finance products originated as a result of innovation are:

a. Sukuk - Initially evolved based on debt-based structures like Murabahah and BBA; later developed
based on equity and leased based structures.

b. Shariah screening stocks: One of the remarkable breakthroughs in Islamic finance innovation. Various
Islamic indices were established and developed standardised Shariah standards.

c. Musharakah Financing - Used for the purpose of asset acquisition such as property financing as an
alternative to BBA property financing. The common structure for this type of financing is Musharakah
Mutanaqisah.

d. Musharakah venture – Used for the purpose of venturing in profit generating business activities

e. Investment Account-i - It is categories as an investment product, providing an opportunity for the

customer to invest in and share the profits from Shariah-compliant investment activities. It caters for
a wide range of investor risk return preferences that reflect the underlying assets performance.

When discussing innovating Islamic financial products, the scholars must be aware that the following
conditions have been taken into consideration:

• Avoiding the prohibited elements such as riba, gharar and maysir.

• Totality in compliance (end to end) to Shariah.
• Using the right contracts: nominate vis-à-vis non-nominate contracts.
• Considering various surrounding issues, e.g. regulatory, taxation, rating, appetite of the clients, etc.
• Of all, the Maqasid Shariah should be the guiding principle in innovation.

There are a number of benefits to replication and innovation including:

1. Having more efficient and effective work processes

2. Cost and time effective

3. Innovation can be a profit centre- it can help drive sales and results

4. Business agility

5. Increased customer satisfaction

6. Compliance with legislation and possible tax benefits

7. Encourages and supports diversity

8. May lead to competitive advantage

Topic 2 Islamic Finance Architecture: Islamic Banking 13

 It is clear that in the rapidly changing financial environment in which the Islamic banks are operating, it is vital
that every player of this sector attempts to ensure both its short term competitive and long-term strategic
presence. Islamic banking institutions need to be continually innovative and create new ideas and new
products. Much of the Islamic products are introduced into the market place by adapting and re-engineering
the conventional products; following the success of the conventional products. While we can accept the
formation of conventional products to Shariah-compliant products, the process of innovation to develop new
products is more encouraged.
Therefore, it is essential for the Islamic banks to move beyond the adaptation of conventional products and
stimulate new ideas that will help the industry nourish and relevant to the market.

14 Topic 2 Islamic Finance Architecture: Islamic Banking

 UNIT 4: ISSUES AND CHALLENGES IN ISLAMIC BANKING

The growth of Islamic banking has outstripped that of conventional banking in recent. The widely-held
expectation that this superior growth record will continue is understandable given that approximately
one-sixth of the world’s population is Muslim–most of which is based in the Middle East and Asia.

Taking note of the demand, a number of western countries have recently started allowing Islamic banks
to operate in their respective jurisdictions. The UK became the first leading western country to issue
a government sukuk (Islamic bond.) Kuveyt Turk Bank, the first full-fledged Islamic bank in Germany
was launched in 2015, while Japanese regulators are considering issuing regulations that will allow
Japanese banks to provide Islamic finance products in Japan. Yet, despite the increased interest,
Islamic banking penetration in non-Muslim countries has been slow as Islamic banks find it difficult to
expand into different jurisdictions and face regulatory and Shariah complications in terms of approvals.

Islamic banks are also finding that it is challenging to cope with the evolving global banking environment
and making appropriate rules and regulations to cope with these changes while still remaining competitive
with their conventional counterparts. Additionally, the industry lacks consistency in product structures and
investment practices that adversely affects its credibility, reputation, perception and regulation capabilities.

The rapid growth of Islamic banking over the years has resulted in the introduction of complex banking
products and structures, which now require Shariah harmonization at a global level. But the challenge
is that there is no central authority promulgating Shariah law, and the understanding of what is hence
permissible and what is not are varies among Islamic scholars and jurisdictions. While conventional
banks have harmonized and approved regulatory standards that banks around the world, this makes
it easier for them to expand and conduct operations in different countries, unfortunately there are
no approved standards per se for Islamic banks as they follow the conventional banking regulations.

Besides the above, some of the issues and challenges being faced by the Islamic banks are tabulated below:
Issues Descrip�ons
Common • To ensure a high level of integrity and transparency of the Islamic financial industry
Standard
• Promote the Islamic financial industry in theory and prac�ce and improving mul�lateral understanding
between Islamic banks, their customers and public at large

• Primary roles include crea�ng awareness, research and development, policies and strategic planning
and cer�fica�on of Islamic financial products

Harmonizing - • Variances and inconsistencies in the interpreta�on of Shariah within a single na�on may hinder the
Shariah progress of Islamic banking in a par�cular country
Interpreta�ons
• The efforts towards standardizing Islamic banking opera�ons with interna�onal opera�ons need to be
con�nued. Among the steps to achieve the standardiza�on is through harmoniza�on of Shariah
interpreta�on in establishing Shariah standards in producing more universal products.

Human Talent • Shortages of skilled work force and human capital in the field of Islamic banking and finance
Development
• Development of the product innova�on needs crea�ve as well as innova�ve Islamic prac��oners

• Number of people who are well versed in knowledge and understanding of the concept of Islamic
system are s�ll small. This leads to the crea�on of Islamic products that are almost similar to the
conven�onal products, rather than coming up with more innova�ve Islamic products that have added
value for consumers.

Topic 2 Islamic Finance Architecture: Islamic Banking 15

 Issues Descrip�ons
Shortage of • Shortage of marketable financial instruments to the market and on top of that, una�rac�ve sets of
Investment instruments are offered which get nega�ve feedbacks from the poten�al investors.
Instruments

Research and • Allocates negligible funds to the training of its staff

Development
• Crucial for realiza�on of the full poten�al of Islamic banking

Technology • Unable to harness the great poten�al of technology as a suppor�ng tool to enhance Islamic finance

Inadequate • Distribu�on channel for the Islamic banking is s�ll rela�vely considered poor compared to conven�onal
banking products.
infrastructure

Table 4: Some of the Issues and Challenges in Islamic Banking

What is Next?
The industry realizes this challenge and certain countries and governments have fostered the development
of the Islamic banking sector. Countries like Malaysia, Bahrain, and Oman have developed separate legal
and regulatory frameworks for Islamic banks to follow, while Qatar has aimed to separate Islamic banking
from conventional banking by banning Islamic windows within conventional branches in the country. Other
countries, like the United Arab Emirates (UAE) and Turkey, have been focusing on promoting Islamic banking
industry and are becoming centres of excellence. Yet despite these improvements, these countries have
been working in isolation rather than collectively to address these issues. As a result, the industry still lacks a
clear strategy and direction to help achieve its potential.

Nevertheless, the industry has taken certain steps; the Islamic Development Bank (IDB) recently echoed
the need for a Global Shariah Advisory Board that offers greater uniformity to the Islamic finance industry.
Also, the Association of Shariah Advisors in Islamic Finance Malaysia (ASAS) was officially registered in 2011
with the objective of establishing a global entity to ensure professionalism among Shariah advisors and
experts in Islamic Finance. The aim of the Association is to “develop Malaysia as a reference center for Islamic
financial transactions” and the country is working on the development of human capital in Islamic finance
and is establishing the necessary Shariah, legal, regulatory and supervisory frameworks. The success of such
associations will rest heavily on individual governments and local regulators to enforce the standards within
their jurisdictions.

It is imperative for the Islamic banking industry to focus on the development of products that foster market
integration and attract investors and entrepreneurs to the risk-return characteristics of the product rather
than concentrating only on its Shariah compliance. Islamic banks need to invest in the research and the
development of new products that are acceptable by the Shariah advisors globally.

At the moment, there is a dilemma as Shariah opinion is diversified, leading to situations where one school
of thought may approve a product or service as being Shariah-compliant only for it to be rejected by another
school of thought. A big step towards achieving harmony would be to set up a central board at a global level
with representation from all different schools of thought.

For harmonizing standards and structures, the industry does encourage ijtihad in the global community
through international conferences and convocations. Organizations such as the Islamic Financial Services
Board (IFSB) and the Accounting and Auditing Organizations for Islamic Financial Institutions (AAOIFI) have
been formed to recommend principles and industry best practices at global levels.

16 Topic 2 Islamic Finance Architecture: Islamic Banking

Islamic banks also need more expert people both in field of Shariah and finance and try to bridge the gap
between Shariah scholars and develop a single authority to assure that the product provided by Islamic
banks is completely in accordance with Shariah rules and regulations. The Islamic banking industry should
also encourage the development of Islamic banking by increasing their employees' knowledge. To improve
staff’s knowledge, the management of the bank must be willingly to invest on training and development for
the staff so as to ensure that their understanding is aligned with the Islamic principles.

Education plays a strong role to create awareness for public on Islamic banking. Through mass media, trainings,
prints, and seminars, information about Islamic banking can be disseminated to the public effectively. The
popularity of social media nowadays like Facebook and Twitter can be used to promote Islamic banking in a
massive scale aggressively and effectively.

In a nutshell, if Islamic banking is to achieve its potential, it needs to be supported by governments and
regulators. Most importantly, all aspects of Shariah compliance need to be properly defined. Ultimately the
harmonization of Shariah compliance is a critically important component to ensuring the stability, which is
intrinsic to the Islamic finance model.

Topic 2 Islamic Finance Architecture: Islamic Banking 17

 PRACTICE QUESTIONS

1. Islamic banking is a system of conducting trade and banking activities that in line with the principles of
Shariah while avoiding all the prohibited activities such as riba, gharar, financing of haram trades and
businesses. In addition to that, what are the other requirements that need to be observed?

A. The avoidance of speculations

B. The avoidance of oppression
C. Promotion of fairness and full disclosure
D. All of the above

2. Fundamentals of Islamic Banking includes:

I. Risk Sharing
II. Prohibition of Usury
III. Economic Purpose
IV. Sanctity of Contracts

A. I and II
B. I, II and III
C. I, II and IV
D. I, II, III and IV

18 Topic 2 Islamic Finance Architecture: Islamic Banking

Topic 3
Islamic Finance Architecture: Takaful

Learning Objectives
At the end of this topic, you will be able to:
• Explain the meaning of takaful
• Explain the main differences between takaful and insurance
• Describe the evolution in takaful industry
• Describe innovation in takaful products and services
• Discuss the issues and challenges in takaful

UNIT 1: INTRODUCTION TO ISLAMIC BANKING

Definition of Takaful
Takaful is a protection scheme whereby a group of participants mutually agreeing among themselves to
contribute (tabarru’) or donate in the takaful funds to guarantee each other against a defined loss or damage
that may befall upon any of them. It emphasises unity and co-operation among participants. Takaful is not a
new concept as it had been practised by the Muhajirin of Mecca and the Ansar of Medina following the hijrah
of the Prophet Muhammad SAW over 1,400 years ago.

Tabarru’ is the agreement by a participant to relinquish as donation, a certain proportion of the takaful
contribution that he/she agrees or undertakes to pay, thus enabling him/her to fulfil his/her obligation of
mutual help and joint guarantee should any of his/her fellow participants suffer a defined loss. The concept
of tabarru’ eliminates the element of uncertainty in the takaful contract. The sharing of surplus that may
emerge from the operations of takaful is made only after the obligation of assisting the fellow participants
has been fulfilled. Thus, the operation of takaful may be envisaged as a profit sharing business venture
between the takaful operator and the individual members of a group of participants.

The Islamic Financial Services Act 2013 defines takaful as “an arrangement based on mutual assistance under
which takaful participants agree to contribute to a common fund, providing for mutual financial benefits
payable to the takaful participants or their beneficiaries upon the occurrence of pre-agreed events.”

Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) defines takaful as follow:

“Islamic insurance is a process of agreement among a group of persons to handle the damages
or losses resulting from specific risks to which all of them are vulnerable. The agreement involves
payment of contributions as donations, and leads to the establishment of an insurance fund that
enjoys the status of a legal entity. The resources of this fund are used to indemnify any participants
who encounter losses. The fund is managed by either a selected group of policyholders, or a joint stock
company that manages the insurance operations and invests the assets of the fund for a specific fee.”

IFSB and International Association of Insurance Supervisors (IAIS) further define takaful as “an undertaking
that consists of a two-tier structure that is a hybrid of a mutual and a commercial form of company – which
is the takaful operator.”

Topic 3 Islamic Finance Architecture: Takaful 19

 Comparison between Takaful and Insurance
No Per�nent Takaful Insurance
Issues
1. Essence of Inten�on is to create both spiritual and legal Inten�on is to create legal rela�on only
Inten�on rela�onships

2. Subject Ma�er Subject ma�er must be Shariah jus�fied Subject ma�er must be Common Law jus�fied

3. Guarantee The takaful operator is only the Fund Manager. The company provides the guarantee
The par�cipants mutually guarantee each
other

4. Fund The fund is managed by the takaful operator for The fund belongs to the Company through
a legi�mate considera�on for the services separa�on of assets and is maintained
rendered between the Shareholders and the
policyholders

5. Payment of Paid contribu�on is treated as a dona�on Paid premium creates an obliga�on against
contribu�on/ (tabarru’) the insurer on a sale and purchase contract
premium

6. Forbidden Islamic model is based on Islamic principles, Insurance policy revolves around the element
Elements and free from the elements of gharar, riba and of gharar, riba and maysir
maysir.

7. Surplus The surplus is shared among the par�cipants The surplus is usually distributed to the policy
and the Operator holders as bonuses or dividend

8. Contract A contract of tabarru’ (dona�on) and agency An exchange contract (sale and purchase)
(wakalah) or profit sharing (mudarabah) between insurer and insured
contract
9. Risks Risks sharing concept among par�cipants Concept of risks transferred from insured to
Treatment insurance company

10. Benefits Paid from the defined funds under joint Paid from the fund legally owned by the
indemnity borne by the par�cipants company

11. Investment Assets of the takaful funds are invested in There is no restric�on apart from those
of Fund Shariah -compliant instruments imposed for pruden�al reasons

Table 5 : Comparison between Takaful and Insurance

20 Topic 3 Islamic Finance Architecture: Takaful

 UNIT 2: TAKAFUL INDUSTRY EVOLUTION
Global Takaful Market Overview
Takaful is one of the important components in Islamic financial ecosystem and it is growing rapidly in the
financial market. While Takaful plays a significant role in the major markets of Islamic finance, its growth is
not in line with the momentum of maturity of other sectors in the Islamic financial ecosystem.

Although the current market economy is experiencing a slowdown in growth caused by the rising inflation
and declining foreign exchange rates, especially in the countries that conduct Takaful business, the total
amount of Takaful contributions is increased by 3.2% in 2018 to reach USD 27.07 billion; a slower growth rate
than the 4.3% reported in 2017. About 91% of the global total contributions in 2018 were generated from
five countries, namely Iran, Saudi Arabia, Malaysia, the UAE and Indonesia.

12,000
10,880
9,463
9,000
USD bilion

6,000

3,000 1,856 1,205 1,057

0
Iran Saudi Malaysia UAE Indonesia
Source: IFSB Secretariat Workings
Diagram 10: Contribution of Top Five Takaful Markets (USD million) (2018)

The global takaful market reached a value of US$ 23.7 Billion in 2019 (iMarc Group 2020). According to a
survey conducted by the IFSB and the Global Takaful Directory 2019, there are about 353 Takaful institutions
in 33 countries globally.

By region, Middle East and South Asia (MESA) has the largest number of Takaful institutions (114), followed
by South-East Asia (SEA) and the GCC, with 106 and 79, respectively (see Diagram 11).

A breakdown by type of operation also is shown in Diagram 12. Accordingly, existing full-fledged Takaful
and Retakaful operators number 222 and 15, respectively, while the corresponding Takaful and Retakaful
windows number 88 and 28, respectively.

Africa MESA

54 114

SEA GCC

106 79

Diagram 11: Number of Takaful Operators Globally by Region 2019

Topic 3 Islamic Finance Architecture: Takaful 21

 Takaful Takaful
Companies Windows
222 88

Total
353

Retakaful Retakaful
Companies Windows
15 28

Diagram 12: Number of Types of Takaful Operations (2019)

As according to the population of Muslims in the countries stated above, Takaful business is seen to have a
very bright potential and opportunities in providing financial protection services in accordance with religious
demands for their customers. However, the success rate of a Takaful operator is highly depending on the
strength and the stability of their business operations. In addition, support from the Shariah scholars in
promoting Takaful product is also very important for the growth of the Takaful sector in this Islamic finance
industry.

Global Takaful Forecast

Over the recent decade, the double-digit growth of Islamic banking assets has been accompanied by a similar
growth of gross takaful contributions across key Muslim developing markets, including Saudi Arabia, UAE and
Malaysia. In spite of takaful’s strong double-digit growth, the insurance penetration rates in these key markets
are generally low (on average just 2%), indicating the possibility of strong underlying growth potential. In the
longer term, given the demographics and economic structures, rapid-growth markets such as Turkey and
Indonesia offer wider upside potential.

Takaful operators can expect positive growth in the dynamic and competitive market. From 2011, the Takaful
industry maintained its expansionary trend of the past eight years, recording a compound annual growth rate
of 8.5% (2011–18). In particular, the GCC countries and ASEAN markets are likely to maintain their current
growth path in the next five years, but their growth quantum is highly subjected to their economic growth.
ASEAN’s dynamos, Malaysia and Indonesia, will be the key markets to watch as they enhance their market
practices, widen their delivery channels and strengthen their regulatory infrastructures. Over the longer
term, the Turkish Government’s aim to triple the share of Islamic banking assets in the country by 2023
(100th anniversary of the republic) with the help of state-owned participation banks and incoming players
will help support the gradual growth of Turkey’s takaful industry.

22 Topic 3 Islamic Finance Architecture: Takaful

Asean Market Overview
According to the IFSB Report 2020, total contributions from the ASEAN Takaful market- mainly Malaysia,
Indonesia and Brunei Darussalam – grew by 8% in 2018 to reach USD 3.02 billion, up from USD 2.8 billion in
2017. Overall, this amount has contributed 11.2% of the total Global Takaful contributions.

Malaysia is currently leading the Takaful industry in the Southeast Asian region. This country has about 15
Takaful operators registered with the Central Bank of Malaysia. The growth prospects of the Takaful sector in
Malaysia are very high because this industry has the support of the government in all aspects coupled with
demographic breakdowns that provide an advantage to them. Extensive product innovation and coverage
will most likely drive the sector's growth as the public is increasingly accepting the model.

Malaysia Market Overview

Family Takaful and General Takaful
The Takaful industry in Malaysia maintained its steady growth both in the family and general segments even
though industry players have faced various challenged. Based on latest data by the RAM’s Takaful Insight,
the local family Takaful industry contributions grew 25% to RM6.2 bil in 2019 (2018: +13%), mainly driven
by the MySalam initiative – the national health protection scheme. Excluding MySalam, growth was still
commendable at an estimated 16%, anchored by credit-related takaful products and the employee benefits
group business.

Meanwhile, the general Takaful industry expanded by a strong 20% (RM 3.3 bil) in 2019 (2018: +10%), led
primarily by the motor business. Somehow, the profitability of the general takaful business is expected to be
strained in the tough economic environment as the segment has seen thin net underwriting margins (2019:
1.5%).

General Takaful Family Takaful

20% New Business 25%

Contribu�on 2019 Contribu�on 2019
RM3.3bil Motor RM6.2bil
13% Motor
Fire Investment
8% Medical & PA 10%
6% 5% 6% 9% linked
Others
4%

Driven by Driven by

Medical & Credit Employee mySalam

Personal related benefits
Motor Fire Accident
+25% +7% +7%

End-Dec End-Dec
2018 2018
293% End-Jun 232% End-Jun
2019 Capital Adequacy Ra�o 2019
231% 194%
Supervisory Target Supervisory Target
Capital Level (STCL) 130% General takaful and family takaful Capital Level (STCL) 130%
capitalisa�on remained adequate

Source: RAM’s Takaful Insight 2020

Diagram 13 : Total Contribution of Family Takaful and General Takaful in Malaysia

Topic 3 Islamic Finance Architecture: Takaful 23
 Malaysia’s Takaful industry outlook for 2020 is expected to remain stable despite the considerable economic
impact of the COVID-19 pandemic. The strong capitalisation of Takaful operators is anticipated to
sufficiently cushion claims incurred from the pandemic related coverage, the impact of heightened financial
markets volatility and mounting credit stress.

According to RAM Ratings Services, the preliminary capital adequacy ratio (CAR) for both the family and
general Takaful industry stood at a strong 207% and 283%. Respectively, equivalent to 1.6 times the minimum
requirement as at end-December 2019.

In developing the takaful industry in Malaysia, the government has adopted a gradual approach which can be
divided into four phases as per table below:
Phase I (1982 -1992)
• Se�ng up of Special Task Force to explore the viability of se�ng up an Islamic insurance company.
• The enactment of a dedicated regulatory law, the Takaful Act 1984, to govern the conduct of takaful business, and
provide for the establishment of Shariah Commi�ees to ensure that the business opera�ons of a takaful operator are in
compliance with Shariah principles at all �mes.
• The establishment of the first takaful operator in 1985 - Syarikat Takaful Malaysia.
• The primary focus was the establishment of the basic infrastructure for the industry.

Phase II (1993-2000)
• The introduc�on of compe��on with the entry of another takaful operator - Takaful Nasional Sdn Bhd.
• Greater compe��on among takaful operators in the region, including the forma�on of the ASEAN Takaful Group in 1995
and the establishment of ASEAN Retakaful (L) Ltd. in 1997.
• Appointment of members of the Shariah Advisory Council of Bank Negara Malaysia for Islamic Banking and Takaful.
• Takaful Malaysia and Takaful Nasional (now known as E�qa Takaful) jointly developed a Code of Ethics for the industry
in 2000.

Phase III (2001-2010)

• Introduc�on of the Financial Sector Master Plan in 2001, which objec�ves include enhancing the capacity of the takaful
operators and strengthen the legal, Shariah, and regulatory framework.
• Takaful Malaysia and Takaful Nasional launched an ini�a�ve in 2001 with the Life Insurance Associa�on of Malaysia to
promote best prac�ces and greater professionalism in the industry.
• Se�ng up of Takaful Ikhlas in 2002.
• Issuance of four new Takaful licenses between 2005-2007.
• Establishment of Malaysia Interna�onal Islamic Financial Centre (MIFC) - to develop intermedia�on linkages in the
global market place.
• Liberalisa�on of the takaful industry in 2009, which saw the issuance of four new family takaful licenses in 2010 to
players that can offer significant value proposi�on to Malaysia to spur the development of the industry.
• Given the push for the introduc�on of more stringent capital requirements, Malaysia has extended the discussion on
risk-based capital (RBC) to takaful. The RBC approach is implemented in 2011.

Phase IV (2010-2020)
• Financial Sector Blueprint is a strategic plan that charts the future direc�on of the financial system as Malaysia
transi�ons towards becoming a high value-added, high-income economy.
• On takaful among others men�oned are encouraging greater involvement of takaful brokers in broadening the range of
takaful product offerings and outreach by extending MIFC incen�ves to such takaful brokerage business ac�vi�es, and
promo�ng the use of takaful as a risk management tool in Islamic financial transac�ons, for instance in Islamic trade
finance transac�ons and sukuk.
• Trade Credit Insurance Policy and Trade Credit Takaful (TCIT) is enforced for the purpose of regula�on with respect to
TCIT offerings, including requirements involving the approval and submission process of informa�on.
• The Takaful Opera�onal Framework issued by BNM is enforced on July 1, 2020. It supersedes the Guidelines on Takaful
Opera�onal Framework.
• Takaful Opera�onal Framework came into effect in January 2012.

Table 6: Initiatives by Malaysian Government in Developing Takaful Industry

24 Topic 3 Islamic Finance Architecture: Takaful

Among the initiatives taken by the Malaysian government via Bank Negara Malaysia (BNM) specifically for
the Takaful industry is the enactment of the Islamic Financial Services Act (IFSA) 2013, the publication of
the Life Insurance and Family Takaful Framework (LIFE) concept paper in 2013, and the issuance of Takaful
Operations Framework (TOF) in 2018. In particular, LIFE has been designed to offer extensive operational
flexibility, product disclosure, provision of channels, and market practices to the Takaful industry in Malaysia.
The government also announced the Takaful plan in the 2020 Budget by offering mySalam health protection
scheme to B40 individuals aged up to 65 and has an annual gross income of up to RM100,000. This initiative
became a reality by collaborating with a Takaful company, Great Eastern Holdings, which has contributed
a start-up fund contribution of RM2 billion into the mySalam trust fund to build better social protection
networks good for Malaysians starting January 1, 2020.

Table 7 summarized the key milestones in Malaysia’s takaful evolution.

Year Milestones
1982 A Special Task Force was established to explore the viability of se�ng up an Islamic insurance company

1984 • Takaful Act 1984 was gaze�ed of se�ng up an

• Incorpora�on of Syarikat Takaful Malaysia
1988 BNM commenced the supervision of the insurance and takaful industry
1993 MNI-Takaful Sdn Bhd commenced opera�ons
1995 Set-up of ASEAN Takaful Group
1997 • Incorpora�on of ASEAN Retakaful Interna�onal (L)
• Ltd in the Interna�onal Offshore Financial Centre, Labuan
• Appointment of members – Na�onal Shariah Advisory
• Council for Islamic Banking and Takaful

1998 MNI-Takaful changed its name to Takaful Nasional Sdn Bhd

2000 STMB and Takaful Nasional jointly developed a code of ethics for the industry
2001 • BNM launched of the Financial Sector Master plan
• Establishment of IBFIM

2002 • Maybank Takaful Bhd commenced opera�ons

• Establishment of the Malaysian Takaful Associa�on
• Malaysia’s Islamic Financial Services Board (IFSB) was inaugurated
2003 Takaful Ikhlas Sdn Bhd commenced opera�ons
2004 Approval in principal granted to Commerce Assets Holdings Bhd to conduct takaful business
2005 Start of opera�onal takaful licenses – Sun Life Malaysia Takaful, HSBC Amanah Takaful, MAA Takaful, Hong Leong
MSIG Takaful & Pruden�al BSN Takaful
2006 Establishment of Malaysian Interna�onal Financial Centre
2008 • Establishment of four Retakaful Operators – ACR Takaful Bhd, MNRB Retakaful Bhd, Munich Re Retakaful
Bhd, Swiss Re Retakaful Bhd
• Inter-Takaful Agreement (ITA)

2009 • IFSB-8 issued takaful governance and IFSB-10 on Shariah governance principles
• Establishment of AIA Interna�onal Takaful Bhd

2010 • IFSB-11 issued solvency for takaful

• Announcement of four new family takaful licenses
• Establishment of Great Eastern Takaful Bhd

2011 • BNM unveiled the Financial Sector Blueprint 2011 -2020

• AIA AFG Takaful, ING Public Takaful Ehsan and AmMet Life Takaful began opera�ons
• IFRS convergence in Malaysia, PIDM Act 2011

2012 Enforcement of Takaful Opera�onal Framework and the revised of Shariah Governance Framework
Topic 3 Islamic Finance Architecture: Takaful 25
2013 • Islamic Financial Services Act 2013 was introduced
• Merger of AIA AFG Takaful Bhd and ING Public Takaful Ehsan Bhd (to be known as AIA Public Takaful Bhd)
 • Establishment of Great Eastern Takaful Bhd

2011 • BNM unveiled the Financial Sector Blueprint 2011 -2020

• AIA AFG Takaful, ING Public Takaful Ehsan and AmMet Life Takaful began opera�ons
Year • IFRSMilestones
convergence in Malaysia, PIDM Act 2011

2012
1982 Enforcement
A Special TaskofForce
Takaful
wasOpera�onal
establishedFramework andviability
to explore the the revised of Shariah
of se�ng up anGovernance Framework
Islamic insurance company
2013
1984 •• Islamic
Takaful Financial
Act 1984 Services Act 2013
was gaze�ed was introduced
of se�ng up an
•• Merger of AIA of
Incorpora�on AFG TakafulTakaful
Syarikat Bhd and ING Public Takaful Ehsan Bhd (to be known as AIA Public Takaful Bhd)
Malaysia
2014
1988 Enforcement of Risk-Based
BNM commenced Capital of
the supervision forthe
Takaful
insurance and takaful industry
2015
1993 Life InsuranceSdn
MNI-Takaful andBhd
Family Takaful Framework
commenced opera�ons was issued by Bank Negara Malaysia
2016
1995 Implementa�on
Set-up of Tabarru`
of ASEAN Takaful contract in Takaful by the Shariah Advisory Council (SAC) Bank Negara Malaysia
Group
2017
1997 Opera�ng Cost Controls
• Incorpora�on of ASEANfor Life Insurance
Retakaful and Family
Interna�onal (L) Takaful Business by BNM
• Ltd in the Interna�onal Offshore Financial Centre, Labuan
2018 •• The MalaysianofTakaful
Appointment Associa�on
members – Na�onal(MTA) introduced
Shariah commission-free online delivery channel to customer.
Advisory
•• Revision of Takaful Opera�ons Framework
Council for Islamic Banking and Takaful (TOF) by BNM.

2019
1998 FWD Takaful changed
MNI-Takaful started itits
opera�ons.
name to Takaful Nasional Sdn Bhd
2020
2000 Takaful
STMB andOpera�onal Framework
Takaful Nasional came
jointly into force.
developed a code of ethics for the industry
2001 • BNM launched of the Financial Sector
Table 7:Master plan
Malaysia’s Takaful Evolution
• Establishment of IBFIM
Under IFSA 2013, all the Takaful companies with composite status are required to separate general Takaful and
2002 • Maybank Takaful Bhd commenced opera�ons
family Takaful business starting in 2018. The objective of this segregation is to ensure that Takaful companies
• Establishment of the Malaysian Takaful Associa�on
can concentrate all theirIslamic
• Malaysia’s expertise on Services
Financial their core business
Board operations,
(IFSB) was inauguratedeither Family Takaful or General Takaful.
This is one of the strategies of regulators in reducing the risks inherent due to the lack of qualified experts
2003 Takaful Ikhlas Sdn Bhd commenced opera�ons
in this Takaful field. The isolation can also to ensure the stability in the takaful industry can be guided by
2004 Approval in principal granted to Commerce Assets Holdings Bhd to conduct takaful business
qualified experts and individuals in the takaful industry.
2005 Start of opera�onal takaful licenses – Sun Life Malaysia Takaful, HSBC Amanah Takaful, MAA Takaful, Hong Leong
MSIG Takaful & Pruden�al BSN Takaful
Different Approaches to Global Takaful Practices
1. 2006 Establishment of Malaysian Interna�onal Financial Centre
Commercial
In essence,
2008 this form ofofestablishment
• Establishment is a kind–of
four Retakaful Operators riskTakaful
ACR sharing
Bhd,mechanism based
MNRB Retakaful Bhd,on Shariah
Munich principles and
Re Retakaful
Bhd, Swiss Re Retakaful Bhd
practices through products and services generally similar to insurance. From the conceptual perspective,
• Inter-Takaful Agreement (ITA)
takaful embodies elements of a mutual entity due to its upholding of cooperative values, brotherhood
2009 • IFSB-8principles.
and solidarity issued takaful
Fromgovernance and IFSB-10
the operational on Shariah governance
framework, principles
it resembles mutual insurance because it has
• Establishment of AIA Interna�onal Takaful Bhd
profit-sharing mechanism among its clients as well as the operator. However, unlike a mutual set-up,
participants
2010 of takaful
• IFSB-11 issued are not atforthe
solvency same time owners or shareholders of the company. Shareholders are
takaful
• Announcement of four new family takaful licenses
a separate body, which are bounded by certain contractual rights and obligations with the participants.
• Establishment of Great Eastern Takaful Bhd
Thus, in the case of takaful, the normal process would entail an incorporation of a corporate entity in
2011 • BNM
accordance unveiled
with the Financial
the company lawSector Blueprint 2011
of a jurisdiction -2020 which a licence will have to be obtained from
following
• AIA AFG Takaful, ING Public Takaful Ehsan and AmMet Life Takaful began opera�ons
the regulator
• IFRS before takaful
convergence businessPIDM
in Malaysia, canActbe 2011
provided. From the standpoint of Shariah, the establishment
of takaful as a commercial or business entity is based on ‘Sharikah al-inan'.
2012 Enforcement of Takaful Opera�onal Framework and the revised of Shariah Governance Framework

2. 2013 • Islamicor
Mutual Takaful Financial Services Act
Cooperative 2013 was introduced
Takaful
• Merger of AIA AFG Takaful Bhd and ING Public Takaful Ehsan Bhd (to be known as AIA Public Takaful Bhd)
Structurally, this form of takaful establishment is owned by its participants who are unrelated to one
2014
another.Enforcement of Risk-Based
It is established to carryCapital for Takaful
out either commercial or social takaful businesses. As the name implies,
under mutual
2015 takafuland
Life Insurance setFamily
up, there are
Takaful no shareholders.
Framework was issuedIn
bythat
Banksense,
Negara strictly
Malaysiaspeaking, its objective is not
for profit,Implementa�on
2016 but more to serve the takaful
of Tabarru` contractneeds of the
in Takaful members
by the who are
Shariah Advisory at the(SAC)
Council same time
Bank theMalaysia
Negara participants.
In general, mutual entities have the following characteristics:
2017 Opera�ng Cost Controls for Life Insurance and Family Takaful Business by BNM
2018 • The
a. Rights Malaysian Takaful
of participants Associa�on
to be members (MTA)
to introduced commission-free
the exclusion of others, online delivery channel
with common to customer.
equitable ownership
• Revision of Takaful Opera�ons Framework (TOF) by BNM.
of the company.
2019 FWD Takaful started it opera�ons.
b. Rights
2020 of members
Takaful toFramework
Opera�onal choose the management.
came into force.

26 Topic 3 Islamic Finance Architecture: Takaful

 c. Its sole business purpose is to provide takaful cover substantially at cost (no margin of profit for the
company).

d. Rights of members to the return of contributions, if any, from the surplus of the takaful fund (net of
claims, reserves, retakaful, and such).

3. Takaful Ijtimai (Social Takaful/Social Security)

Basically, this form of takaful establishment is government-run/funded or donor-run/funded entity. It is
set up with a certain priority, for example, to cater to the needs of certain targeted sections of the society
such as the low-income group that is not normally served by commercial takaful or insurance companies
in view of the latter’s profit-oriented goal. Under the takaful ijtimai structure, products may include
micro-takaful and rural takaful schemes usually covering agriculture and livestock built on the premise
of social security practice. The International Labour Organization (ILO, 1984) defines Social Security as:

“…the protection which society provides for its members through a series of public measures against the
economic and social distress that otherwise would be caused by the stoppage or substantial reduction
of earnings resulting from sickness, maternity, employment injury, invalidity and death; the provision of
medical care; the provision of subsidies for families with children…”

4. Microtakaful
This is a form of takaful which essentially provides cover for the poor or largely under-paid populace
in the community which are under-served by the takaful and insurance industry simply due to obvious
reasons such as affordability, uneconomical, reach, and scope of cover. Micro-takaful may be defined
as a takaful product that provides cover to the poor against risks such as accident, illness, death, natural
disasters and the like. In consideration for providing the cover, the participant will pay a small periodical
contribution, commensurate with the participant’s level of income and risk. Usually the product is
clustered on a group basis, which further helps to reduce the contribution rate. Exposure of risk to the
takaful fund is relatively low due to the fact that the sum covered is low and well spread, coupled with
the fact that it falls in line with the principle of law of large numbers.

It is usually offered as a package with micro-finance facilities provided by financial institutions, government
agencies and donor organizations. Perhaps without micro-takaful and micro-finance, a poor person may
end up in the state of abject poverty in the event of a disaster or catastrophe befalling him. In Islam, this
is a most commendable effort as it complements the institutions of zakat, waqf and sadaqah in providing
sustenance and assistance to the less fortunate members of the society.

Topic 3 Islamic Finance Architecture: Takaful 27

 UNIT 3: PRODUCT INNOVATION IN TAKAFUL

The idea of takaful dates back to the seventh century, but the first modern takaful company was set up in
Qatar in 1978, and it was only in 1985 that the International Islamic Fiqh Academy of OIC recognized it as the
Islamic-approved alternative to insurance.

Several models developed marked the milestones in the development of takaful industry. The main stages of
takaful are as follows:

1979 : The first ta’awuni model (cooperative) was developed in Sudan

1984 : The mudarabah (profit sharing) (co-operative) model was

developed in Malaysia.

1984 : The wakalah (agency) model was developed in the Gulf.

1996 : The waqf model was developed in South Africa.

The above models have become the basic structures for the various existing takaful products.

There are four (4) main models for Takaful operators, namely the partnership profit-sharing model
(Mudarabah), agency model (Wakalah), combination of Mudarabah and Wakalah model, and Waqf model.
The Mudarabah model was the first model used during Takaful's introduction in Malaysia, as adopted by the
Takaful Malaysia Berhad. The Mudarabah model only allows its participants to share the return on investment.

This model was later modified to allow sharing in investment return on the contribution pool and any
underwriting surplus. In the later years, the majority of the takaful operators used either Wakalah or modified
Mudarabah model. This model becomes the most popular operating model globally. Pakistan then pioneered
another takaful model, namely, waqf. This model focuses on the tabarru' aspect while the management and
the operational aspect of the Takaful fund may still use either the Mudarabah or Wakalah model.

Diagram 14 and 15 are some examples of product innovation in Takaful:

Current Constraints
Health takaful limited during employment only Underwriter declines applica�on a�er re�rement age

Innova�ve Proposi�on
Accumula�on of funds �ll re�rement age Gratuity amount is allocated solely for reimbursement of
health related expenses

Results
Employees are covered during employment Re�rees are covered via gratuity fund

Diagram 14: Product Innovation in Takaful – Health Retirement Scheme

28 Topic 3 Islamic Finance Architecture: Takaful

 Current Constraints
MRTT approval process is �me consuming (7-14 days) via Delays in financing disbursement at the bank
manual applica�on

Innova�ve Proposi�on
Introduced online submission Smart underwri�ng technology adopted

Results
Approval process is almost real �me Ease of doing business at the bank

Diagram 15: Product Innovation in Takaful – MRTT E-Submission

Topic 3 Islamic Finance Architecture: Takaful 29

 UNIT 4: ISSUES AND CHALLENGES IN TAKAFUL

1. Challenges
The takaful industry is relatively young, but has been recognized to have made its mark as seen from
its exponential growth globally. In Malaysia, its average growth has been double digit since its debut
in 1985. This strong growth, registered consistently for more than 30 years, is propelled mainly by the
family takaful. Nonetheless, as a way forward, the industry has to improve its operation both in terms
of system and structure in order to face various challenges ahead. In this respect, some of the major
challenges that need to be addressed to are as follows:

a. Market Reach
Despite of having been in operation for years, and having increasing number of players, the penetration
rate for takaful has been dismal, at less than 12 percent, which is of 20 percent by the same period.
In this respect, new marketing strategies ought to be planned and implemented by takaful operators.

b. Product Innovation
After being in the market for the last 30 years, takaful needs to move into its next phase of development
in order to meet the complex and changing needs of the public. They demand takaful products that
are tailor-made to match their needs and aspirations both in product design and delivery. This need
is heightened by the strong competition for market share by the conventional insurance. Product
innovation is therefore a most pressing concern for takaful operators to ensure its continued growth
and sustainability. By definition, product design is concerned about future trends in competition
and market share. The great progress in innovation, which is transforming other financial services
industry, should provide a catalyst for takaful operators to move forward in their pursuit of product
innovation. In a nutshell, product innovation means the ability to meet the prevailing needs of the
community, and for takaful, it must be Shariah-compliant.

c. Human Capital
As a service industry, the growth and development of takaful greatly depends upon the quality of its
human capital. The sophistication and increased requirement of consumers can only be matched
with adequate and professionally trained and skilled manpower, including having Shariah knowledge.

With the migration of personnel from the conventional industry to takaful, the need for developing
Shariah-savvy staffs and technical-savvy scholars becomes a critical challenge.

The commendable efforts by institutions such as IBFIM and Islamic Research and Training Institute
(IRTI) and many other industry institutions, as well as the various institutions of higher learning where
the teaching, study, research and training of Islamic finance including takaful, should be further
promoted and enhanced. There is still a dearth of literature on the various technical aspects of the
business. More literature and research on issues of retakaful, alternative risks transfer mechanism,
microtakaful, consumer behaviour, accounting, investment, marketing, relevant Shariah issues in light
of Maqasid Shariah, legal and regulatory issues, are needed because without them, the industry will
lack in the depth and breadth of the business as compared to the conventional market are required.

d. Technology
As technology is business by itself, takaful industry will face a big challenge in enhancing its operation
without matching the advances in relevant technologies. In order to remain competitive, takaful

30 Topic 3 Islamic Finance Architecture: Takaful

 needs to embrace a comprehensive technology advances in sharpening its operational efficiency,
delivery and service. As a matter of fact, the corporate governance of takaful as a whole highly
depends on technology. Technology is also essential for the advancement of marketing. With
demographic changes leading to better education and knowledge takaful operators must be fully IT-
savvy. The use of technology has expanded vertically and horizontally. Buying and selling of products
and services are not only confined by way of online, but also included social media channels such as
Facebook, twitters and others. In Malaysia, for example, online cover note through the ‘e-cover-note’
service has been in operation for a number of years and so is the payment online for family takaful
instalment.

e. Legal and Regulatory Infrastructure

Lack of appropriate infrastructure of the above should be addressed immediately. As can be seen
in most jurisdictions, there is no comprehensive legislative and regulatory framework for takaful. In
practice, regulations pertaining to takaful are supplemented within the conventional statutes. Unlike
insurance law, which has evolved over the past two hundred years, takaful is still at its nascent stage.
The thousands of legal cases in various countries have placed the legal infrastructure of insurance
on a firm footing. The need to develop, compile and construct a comprehensive body of law in light
of the Shariah with regards to the takaful industry is a herculean task that needs to be undertaken.
Without this comprehensive body of law, the takaful industry will be exposed to uncertainties that
may affect its long-term integrity and sustainability. Takaful, as a Shariah-compliant entity, should
operate within the realms of Islamic tenets.

2. Takaful Trends and Growth

Compared to the penetration rate of insurance of the developed countries, which is in double digit against
its GDP, the similar rate for OIC member countries is, on average, well below 5 percent while countries
that posted less than 1 percent are relatively large in number. Efforts ought to be undertaken to increase
the penetration in the latter countries by promoting the takaful industry. Therefore, takaful operators
with the support of the respective authorities should strive to develop and execute new strategies.

Source: SIGMA4-2015

Diagram 16: Insurance Penetration Rate as a Percentage of GDP of Selected Muslim Countries and Developed Countries

From the above data, it is apparent that as compared to the developed economies, most Muslim majority
countries have a relatively low insurance penetration rate. On the positive side, this represents immense
potential for takaful to be developed as a viable alternative for conventional insurance.

Topic 3 Islamic Finance Architecture: Takaful 31

 A number of factors in favour of takaful to further grow can be summarised as follows:

a. Growing Population
The increase of population, particularly, among the Muslims worldwide, which currently exceed 2
billion, would create huge market potential for takaful products. OIC member countries at present,
account for only 5 percent of the global insurance premium, despite representing about one-quarter
of the world population.

b. Demography
Generally, the population of the Muslims are young, with 70 percent below the age of 35 years, which
is the composition trend in Malaysia. They are increasingly better educated, knowledgeable and well
informed. As the trend demonstrates in the developed world, with improved education, the demand
for insurance products among its young population increases with the realization for the need of
long-term financial planning. With the development of consumerism, the takaful industry would
need to develop innovative products that can meet the growing insurance needs of the society. New
channels of distribution such as the internet and e-commerce have to be developed as the young
population are more IT-savvy.

c. Growth of Islamic Finance

Islamic banking and finance have been growing at a phenomenal rate globally. For example, in
Malaysia, the share of Islamic banking currently is more than 32 percent of the total banking industry
as at 2019. As banking operations would require insurance cover, the strong growth of Islamic banking
would mean increasing demand for takaful services. Likewise, the advancement of the Islamic capital
market would push for bigger demand for takaful products such as unit-linked takaful, which in turn
would boost the level of savings of a country. In tandem with this, all endeavours must be taken to
forge close working relationship with other players in Islamic finance. Players and all stakeholders
within the Islamic finance realm must complement and supplement each other.

d. Economic Growth
Although the world was engulfed with an economic downturn in the recent past, most OIC countries
have enjoyed encouraging growth momentum. With the economy of a country growing, the
economic standing of its population will be further improved. Employment would be easily available,
the population would be more affluent and per capita income increasing. The need for savings and
long term financial planning among the people would mean higher demand for takaful product.

e. International Cooperation
At the international level, the working relationship to promote takaful worldwide between the various
regulators as well as the industry players shall be a conduit towards the expansion of takaful operators
globally. Through such cooperation, takaful operators, either at the individual organizational level or
through its national associations, will be able to plan, arrange and forge meaningful cooperation
such as setting up joint-ventures, exchanging of retakaful business, technical assistance, and sharing
Shariah expertise with the primary objective of promoting the takaful industry.

It is also most heartening to note that from the humble beginning of the first loose grouping among takaful
operators in this region, called the Asean Takaful Group (ATG) formed in 1995, it has now expanded globally.
In fact, ATG, whose primary aim was to provide a platform for retakaful cooperation through the ATG Pool
mechanism, was the basis in the establishment of the first full-fledged retakaful operator in the world—

32 Topic 3 Islamic Finance Architecture: Takaful

Asean Retakaful International (L) Ltd (ARIL). From three founding members of Malaysia, Indonesia and Brunei,
the group has since been enlarged into the Global Takaful Group (GTG) comprising takaful operators around
the world. This international grouping of takaful and retakaful operators is aimed at fostering close rapport
and cooperation among takaful operators around the world.

To develop a harmonization of governance, the role of IFSB and AAOIFI in issuing guidelines and standards
would help towards the convergence of takaful operation globally. All in, this will propel the overall growth of
the industry, which ultimately will enable us to fulfil the financial and insurance requirements of all Muslims
and non-Muslims alike in accordance to requirements of Shariah.

Topic 3 Islamic Finance Architecture: Takaful 33

 PRACTICE QUESTIONS

1. Takaful is based on the principles of mutuality and co-operation, encompassing the elements of shared
responsibility, joint indemnity, common interest and solidarity. Which of the following Islamic elements
are employed under Takaful system?
I. Ta’awun
II. Tabarru’at
III. Losses are divided and liabilities spread according to the community pooling system.
IV. It does not seek to derive advantage at the cost of others

A. I and II
B. I, II and III
C. II, III and IV
D. I, II, III and IV

2. Which of the followings are the prohibited elements practiced under Insurance?
I. Riba
II. Gharar
III. Maysir
IV. Tabbaru’

A. I and II
B. I, II and III
C. II, III and IV
D. I, II, III and IV

34 Topic 3 Islamic Finance Architecture: Takaful

Topic 4
Islamic Finance Architecture: Islamic Capital Market

Learning Objectives
At the end of this topic, you will be able to:
• Explain the basic components of Islamic capital market
• Describe three major instruments in Islamic capital market namely sukuk,
• Shariah-compliant equity and Islamic funds
• Discuss the issues and challenges related to Islamic capital market

UNIT 1: OVERVIEW OF ISLAMIC CAPITAL MARKET

The term capital market refers to a part of a financial system that raises capital by dealing in shares, bonds,
and other investments. Islamic Capital Market (ICM) operates within the same institutional and regulatory
framework as that of conventional capital market, except that all aspects of investment and financing activities
and products must be structured in accordance with the Shariah.

ICM products and services are based on the fundamentals of Shariah that requires all associated activities
in ICM to be conducted in an ethically and socially responsible manner that comply with teachings of Islam.

Shariah requires all manner of activities to be free from riba, gharar, maysir, and prohibited commodities
(liquour, pork, etc.) while further complying with the contractual requirements of investments/trading as
required by the Shariah.

Generally, ICM can be divided into three categories:

1. Industry players – refers to the industry that actively involved in daily activities of ICM.

2. Instruments – ICM products and services offered.

3. Support industry - other industries that support ICM activities.

Islamic Capital Market

Industry Players Instruments Support Industry

(Issuer, Arrangers, Fund Managers, (Equity, Sukuk, Funds etc.) (Legal, Audit, Shariah, Taxa�on, Ra�ng, etc.)
Asset Managers, Investors, etc.)

Diagram 17: Division of ICM

The involvement of the industry players and role of the support industries can be explained as in Diagram
18. As an example, an issuer of sukuk will be supported by an array of advisers for the issuance of the
instruments. Legal adviser, Shariah adviser, accounting firm, etc. will work together with the arranger of the
sukuk to structure the sukuk together with its relevant documentation prior to issuance of the sukuk. The
finished product, after obtaining all relevant approval from the regulators will then be made available to the
market for subscription by the investors.

Issuer Instrument Instrument

Supported by: • Equity • Fund managers
• Arrangger • Shariah • Sukuk • Asset managers
• Legal • Taxa�on • Funds • Inverstment houses
• Audit • Ra�ng • Pension Fund

Diagram 18: Components of Islamic Capital Market

Topic 4 Islamic Finance Architecture: Islamic Capital Market 35
 UNIT 2: ISLAMIC CAPITAL MARKET INSTRUMENTS

ICM products and services are available for investors through two channels:

1. Private placement
Private placement is a method to raise small amount of capital (circa below USD50 millions) and normally
only offered to selected investment firms or individuals.

2. Publicly issued
Publicly issued instruments are for raising huge capital. In 2016, TNB Global Ventures Capital Bhd, a
wholly-owned subsidiary of Tenaga Nasional Bhd, established a multicurrency sukuk issuance programme
to the tune of US$2.5bil.

The difference between public and private placement lies from regulation perspective. A public placement
is subjected to numerous financial requirements by the regulators to be complied with, whereas a private
placement exercise is exempted from these encumbrances.

Thus, in issuing an ICM product, the issuer needs to identify its funding requirements which will then be
translated to the most appropriate instruments to be issued. As an example, an infrastructure project that
cost billions is most suitable for sukuk issuance, and equity is an option to expand one’s business. However,
there is no fix rule or regulation that limits the kind of instruments issued and the funding requirements.
Instruments Issuer
1. Sukuk • Governance • Quasi governance • Corporate
2. Equity • Corporate
3. Funds • Listed • Unlisted • Fund houses

Table 8 : ICM Instruments and its Issuer

Sukuk remains the most flexible instrument for issuance. Compared to equity, where there are numerous
requirements to be eligible for issuance - mostly financial performance, sukuk can be issued by any entity,
private or public sector requiring large sums of capital.

Equity, on the other hand, can only be issued by corporate sector. Eligible companies, through the arranger
(investment banks) can apply for listing at the stock exchange from the regulator for such industry (such as
respective country’s securities exchange). These companies will undergo various screening by the regulator
to determine its eligibility for such exercise.

Meanwhile, Islamic funds remain an exclusively to fund houses for issuance. Capital raised from this sector
mostly formed the last leg to complete the cycle of ICM. Most ICM instruments, such as sukuk and equities
are subscribed by Islamic funds to fulfil the purpose of its creation.

Basically, there are three major instruments in Islamic capital market: sukuk, Shariah-compliant equity and
Islamic funds.

1. Sukuk
Sukuk ( ), the plural of sakk ( ), literally means financial certificates. The Accounting and
Auditing Organisation for Islamic Financial Institutions (AAOIFI) Standard 17, defines sukuk as follows:

36 Topic 4 Islamic Finance Architecture: Islamic Capital Market

 “Certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and
services or (in the ownership of) the assets of particular projects or special investment activity.”

Sukuk is an asset monetisation. It is a financial process, by way of asset securitisation, or known as ‘taskik’
(sukuk issuance). Here pools of Shariah-compliant assets are packaged and structured into securities
based on a specific contract of exchange – such as Ijarah , Salam, Istisna’, Murabaḥah , etc.

The structuring process will undergo various Shariah-compliant transaction – e.g: sale and purchase of
an asset, leasing of specific assets or participation in a joint-venture business, before the final product is
available for subscription.

The development of sukuk was in response to Shariah-compliant prohibition on earning interest from
loan contracts where by such coupon payment are based on interest. Conventional bonds and other
derivative instruments that rely on profiting holders by providing returns based on interest are therefore
unavailable to Muslims who wish to invest in Shariah-compliant investments.

Sukuk issuance transgress the boundary between private sector and public sector. All over the world, the
participation of these sectors in sukuk issuance has taken a tremendous hike in recent years. Sukuk is
considered to be the fastest growing component of the activities constituting Islamic finance in general.
200 600
180
500

Outstanding (USD Bilions)

160
Issuances (USD Bilions)

140
400
120
100 300
80
60 200
40
100
20
0 0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Sukuk Issuances Sukuk Outstanding
Source: Thomson Reuters Eikon, Bloomberg and data received directly from regulators
Diagram 19: Global Sukuk Issuances and Sukuk Outstanding Trends (2004–2019)

Sovereign issuers continue to lead the sukuk market. Consistent with past trends, sovereign and
government-related issuers remain the largest issuers by value, making up over half of the annual global
issuances in 2019 as shown in Diagram 20.
Mul�lateral
Sovereign Corporate Organisa�ons

56% 36% 8%

Source: Thomson Reuters Eikon, Bloomberg and data received directly from regulators

Diagram 20: Sukuk Issuances by Issuer Type (2019)

Topic 4 Islamic Finance Architecture: Islamic Capital Market 37

 The popularity of sukuk also has seen a significant rise. In 2013, for the first time, the total amount
of sukuk issued worldwide exceeded the amount issued by Malaysian issuers in all currencies. Among
the new entries of sukuk issuer are from non-Muslim countries. Long term sukuk were issued in record
number of new jurisdictions, such as South Africa, United Kingdom, Hong Kong and Luxembourg.

The process of structuring a Sukuk is based on the Shariah contracts used. Various Shariah contracts such
as Wakalah, Murabahah, and Ijarah are used to structure Sukuk. In the beginning, Shariah contracts
such as Bay’ Bithaman Ajil (BBA) are frequently used to issue Sukuk in Malaysia. However, under the
opinions and views of Shariah scholars from the Middle East, Shariah contracts other than BBA contracts
then have been used in the structuring of Sukuk. The Sukuk framework that consists of different Shariah
contracts is now no longer considered new to this day.

Historically, ṣukuk issuances have been largely concentrated on Murabahah-based contracts followed by
Ijarah-based contracts. However, in addition to these two contract types, there has been a gradual shift
towardsincreasing utilisation of Wakalah-based contracts as well as hybrid contracts. Nonetheless, the
majority of ṣukuk issuances continue to be based on debt or lease-type contracts, suggesting that the
market still favours contract types that are considered to have stable return profiles.
Musharakah Salam
Mudarabah 3% 1%
8%
Hybrid Murabahah
31%
14%

Ijarah Wakalah
20% 23%
Source: Thomson Reuters Eikon, Bloomberg

Diagram 21: Sukuk Issuance by Structure (2019)

Based on the diagram 21, Sukuk based on debt contract such as Murabahah, Wakalah and Ijarah have
pioneered most of the issuance of Sukuk structure globally. Sukuk for Murabahah contract recorded
the highest percentage figure which is 31%, followed by Sukuk for Wakalah contracts (23%) and Ijarah
contract of 20%.

Meanwhile, the issuance of Sukuk structure by mixed contracts or known as hybrid covers 14% of the total
contract and for Sukuk based on equity contracts, namely Mudarabah and Musharakah, respectively,
recorded a percentage of 8% and 3%.

Both contracts have become less popular since 2008 when a statement issued by a prominent figure in
Islamic finance, Sheikh Taqi Usmani, in 2007, strongly criticised the authenticity of sukuk based on these
two Shariah contracts. In his arguments, about 85% of Sukuk based on Mudarabah and Musharakah
contract at that time were not fully compliant with Shariah rulings mainly because their method for the

38 Topic 4 Islamic Finance Architecture: Islamic Capital Market

 redemption incorporates a purchase undertaking. However, later on February 2008, the AAOIFI Shariah
Board discuss this and subsequently produced an additional guideline on the Sukuk structure to avoid
further risk and disputes.

It should be noted that the usage of any chosen Shariah contract in sukuk structuring must mostly suit
the demand of the issuer. Similar to any fixed income or debt instruments, the financial side of the
instruments play a vital role in choosing the most suitable Shariah contract for the sukuk structure.
Elements such as taxation, fees and legal should be in an equation when structuring a sukuk.

Though majority of sukuk issued are only available to high net worth and institutional investors, exchange
traded sukuk (a.k.a. retail sukuk) is meant for the retail market. Retail sukuk is listed on an exchange and
it behaves similarly to a listed equity. It is quoted on the exchange and subjected to market volatility and
forces.

This instrument was first issued by the Indonesian Ministry of Finance in 2008. Malaysian government,
through its entity, Danainfra Nasional Bhd, issued its first retail sukuk in 2013 and Pakistan Pakistani utility
K-Electric rightly after. Retail sukuk is seen as of the initiative to raise awareness in Islamic investment due
to its sheer market penetration as compared to the traditional “meant for high net worth and institutional
investors” type of sukuk.

2. Shariah-Compliant Equity
Equity, by accounting definition, refers to the net amount of funds invested in a business by its owners,
plus any retained earnings. It is also calculated as the difference between the total of all recorded assets
and liabilities on an entity's balance sheet.

From capital market perspective, equity refers to the different types of securities available that can
provide an ownership interest in a corporation. In the investment universe, equity refers to common
stock and preferred stock.

Similar to the normal equity available in the market, Shariah-compliant equity is part of the equity market
universe. The main difference between Shariah-compliant equity and its counterpart is Shariah-compliant
equity must at all times comply with the Shariah in all aspects, be it its business side or the financial side.

For an equity to be classified as Shariah-compliant equity, it must pass certain Shariah screening,
commonly referred to as Shariah stock screening. Currently, the most prominent provider of Shariah
stock screenings are:

a. Securities Commission Malaysia

b. S&P Dow Jones Islamic Market Indices

c. MSCI Islamic Index Series

d. FTSE Shariah Global Equity Index Series

All four institutions above applied their unique Shariah screening methodologies in the filtering process
to determine its Shariah-compliant status. In Malaysia, the Shariah status for listed securities on Bursa
Malaysia is screened by its regulator namely Securities Commission Malaysia. Generally, the screening
process adapts the approach of sectoral and financial screening benchmarks in determining Shariah
status of the listed securities. The securities will be classified as Shariah-compliant in the business activity
ratios and their financial ratios are below that benchmark.
Topic 4 Islamic Finance Architecture: Islamic Capital Market 39
 Shariah-compliant
stock
Contribution of non-
compliant activities
and income <5% or Total debt or
<20% cash <33% Positive Image

1. SECTORAL SCREENING 2. FINANCIAL SCREENING

Contribution of Shariah non- Contribution of interest-
Stock bearing debt and liquid asset 3. IMAGE SCREENING
compliant business activities
and income. in conventional accounts.

Contribution of income Total debt or Negative Image

from non-compliant cash >33%
activities >5% or ≥ 20%
Shariah non-
compliant stock

Diagram 22: Shariah Stock Screening Process

40 Topic 4 Islamic Finance Architecture: Islamic Capital Market

 Financial and sectoral screening benchmark

Contribution from the Shariah non-compliant activities for the company's business will be calculated and
evaluated with the following benchmarks:
Securi�es
Commission Dow Jones MSCI FTSE
Screening Securi�es Commission Dow Jones Islamic MSCI Islamic Index FTSE Shariah Global
Methodologies Malaysia Market Indices Series Equity Index Series
Sectoral Income from prohibited ac�vi�es not more than 5%. For example:
Screening • Conven�onal financial services;
• Casinos/gambling;
• Insurance
• Packaging and processing or any other ac�vity related to pork and non-halal food;
• Adult entertainment such as pornographic films and services, music and cinema;
• Produc�on and distribu�on of tobacco

Addi�onal criteria 20% - - -

benchmark for ac�vi�es
such as following:
• Stock broking
• Stock trading
• Rental received from
Shariah non-compliant
ac�vi�es
• Other ac�vi�es that
violate Shariah rules
Financial Total business income Total business income Total business income i. Cash and interest
Screening no over 33% for the no over 33% for the no over 33.33% for the bearing items are less
following ac�vi�es: following ac�vi�es: following ac�vi�es: than 33.333% of total
assets.
i. Cash over total asset i. The sum of a i. Cash and interest
Cash only includes cash company’s cash and bearing securi�es ii. Debt is less than
placed in conven�onal interest bearing securi�es divided by total assets; 33.333% of total assets.
accounts and divided by trailing 24-
instruments wheareas month average market ii. Total debt divide by iii. Accounts receivables
cash placed in Islamic capitaliza�on; total assets; and cash are less than
accounts and 50% of total assets.
instruments is excluded ii. Total debt divided by iii. Accounts receivable
from the calcula�on. trailing 24-month average and cash divide by total
market capitaliza�on; assets.
ii. Debt over total asset
Debt only includes iii. Accounts receivables
interest-bearing debt divided by trailing 24-
whereas Islamic month average market
financing or Sukuk is capitaliza�on.
excluded from the
calcula�on.
Sources: IBFIM, Shariah Business Advisory (2019)

Diagram 23: Comparison of Sector-based Screening and Financial Screening Benchmarks

In addition to the above two-tier quantitative criteria, Securities Commission Malaysia applied another
level of screening – the qualitative approach. Here, Shariah Advisory Council of the Securities Commission
take into account the qualitative aspect which involves public perception or image of the company’s
activities from the perspective of Islamic teaching

In summary, Shariah-compliant equity should evolve as a go-to-instrument to the investing public. Apart
from being Shariah-compliant, Shariah-compliant equity indirectly will also offer a socially responsible
investment through its elimination of certain industry such as weaponry, tobacco related industries,
etc.

Topic 4 Islamic Finance Architecture: Islamic Capital Market 41

 3. Islamic Funds

Islamic fund is a fund which meets all of the requirements of the Shariah, where all aspects of the fund such
as investment, management, process and procedures MUST comply with the requirements of Shariah.
Operationally, for a fund to be classified as an Islamic fund, the appointment of a Shariah board to oversee
the fund’s compliance with the Shariah is a must. Furthermore, as a further level of prudent management,
an Islamic fund must carry out Shariah audit to further ensure all its activities does not deviate from Shariah.
Islamic fund can be grouped into two categories:

a. Listed Islamic funds

Listed Islamic fund can be recognized as a fund that is listed on stock exchange. Islamic Real Estate
Investment Trust (Islamic REIT) and Islamic Exchange Traded Fund (Islamic ETF) are two types of
Islamic funds that fall into this category.

b. Unlisted Islamic funds

Unlisted Islamic fund are the most common Islamic fund available in the market. The name of Islamic
mutual fund or Islamic unit trust fund (depending on the country its offered) is the most popular
unlisted fund.

All the above mentioned Islamic funds carry these common traits:

a. an investment vehicle that invests primarily in Shariah compliant investment.

b. must appoint Shariah adviser or Shariah panel to advise on all Shariah aspects.

c. must perform Shariah audit to ensure all fund’s activities are in compliance with the Shariah.

4. Islamic Real Estate Investment Trust (Islamic REITs)

Islamic REITs literally is a collective investment vehicles that pool money from investors to buy, manage
and sell real estate that generate Shariah-compliant income. It offers investors who wish to invest in real
estate through Shariah-compliant capital market instruments. Rental incomes from the real estate or
companies will be used to provide returns to its unit holders. Hence, to ensure the investment objectives
of the Shariah conscious investors are met, the Islamic REITs manager will conduct tenants review
periodically in ensuring Shariah-compliant of the REITs portfolio. A portion of the Islamic REITs fund can
also be invested in other Shariahcompliant instruments for extra return. This feature mainly used for
maximising return from excess cash. Moreover, this allowance can also be viewed as a diversification tool
to mitigate uncertainties in the real estate market, such as loss of tenants due to economic slowdown.
Islamic REITs served as a new asset class for investment opportunity. It is a tool for investors to manage
their investment risk by way of providing a steady income stream through its annual dividend payment
(as most REITs has very high dividend pay-out policy) or occasionally a surprise special dividend when
an asset is disposed from the portfolio. Islamic REITs provides opportunity for retail investors to gain
a foothold or exposure to large Shariah-compliant commercial properties. Islamic REITs also provides
opportunities to hold stakes in high-grade Shariah-compliant real estate which may otherwise have
been difficult or impossible for a retail investor to hold without the need for direct ownership of such
properties.

42 Topic 4 Islamic Finance Architecture: Islamic Capital Market

5. Islamic Exchange Traded Fund (Islamic ETF)

Islamic ETF is a fund that tracks an index or a basket of assets. It is listed on a stock exchange and behaves
similarly to an equity. Islamic ETF trades is similar to a common equity on a stock exchange, thus shares
the same risk such as experiencing price changes throughout the day as they are bought and sold. Islamic
ETF is expected to offer higher daily liquidity due to the ease in its trading. Structurally, Islamic ETF is
a fund which owns the underlying assets (shares of stock, commodities, etc.) and divides ownership
of those assets into shares. Islamic ETF offers investment diversification, through the fund exposure to
basket of investment. It offers investors an entry to a specific basket of asset class for the fraction of the
price of investing into the portfolio. As an example, an Islamic ETF that tracks the performance of a stock
index will be investing in almost all the listed stocks in the index. It will be almost impossible for a retail
investor to imitate the same strategy by buying all the underlying stocks in that particular index. Thus,
through investing the particular Islamic ETF, the investor will directly gain an exposure to the index and
indirectly to the stocks in the index. It should be noted that Islamic ETF’s investors do not directly own
or have any direct claim to the underlying investments in the fund (i.e. the basket of stocks), rather they
indirectly own these assets through their holding of the Islamic ETF units.

6. Islamic Mutual/ Unit Trust Fund

Islamic mutual/unit trust fund is a fund which meets all requirements of the Shariah, but is not limited
to investment, management, process and procedures. Hence, to reach the aforementioned objectives,
Islamic mutual/unit trust fund must further appoint a Shariah advisor/committee/board to ensure all
activities of the fund, from its formative stage until a time when the fund is no longer in operation.

Appointment of a party to perform Shariah audit is an essential part of Islamic mutual/unit trust fund
operation. Shariah audit is meant to ensure all its activities does not deviate from the Shariah. Shariah
auditors, through their knowledge in both Shariah and operational fields, are seen as an essential
component is Islamic mutual/unit trust fund operational activity. Shariah auditors will complement the
existing fund’s auditors to ease the mind of the Islamic mutual/unit trust fund’s investors by managing
and administering their investments in accordance to Shariah.

Islamic mutual/unit trust fund is categorized according to its assets: equity fund, sukuk fund, income
fund, or a mix fund. This classification can be recognized from the fund’s asset allocation. Normally a fund
is categorized into any of the four if the fund’s asset allocation exceeds 50% in any asset class. An Islamic
mutual/unit trust fund offers its investors an exposure to any given asset class for a fraction of the cost in
investing in the actual asset class.

a. Equity Fund

Islamic equity fund invests its asset predominantly in equities. Its performance will be measured against
a stock index performance. Equity fund carries the highest risk among the four categories due to its asset
class. As prices of equities may vary from time to time and greatly depends on the performance of the
world equity market, especially the developed market such as the United States and Europe as any move
in these markets will affect the performance of the world’s equity market.

Topic 4 Islamic Finance Architecture: Islamic Capital Market 43

 b. Sukuk Fund

Sukuk fund, will invest in all types of sukuk: short-term sukuk, middle-term sukuk or long-term sukuk. The
selection of investment appetite for a sukuk fund depends on the objective of the fund itself— whether
the fund is positioning itself as a short, medium, or long term investment vehicle.

c. Income Fund

Income fund, or sometimes referred to as a cash fund, is a fund that invests mostly in highly liquid
instruments. Cash placement or short-term sukuk are two of the most assets an income fund will be
invested in. This fund is most suitable for corporate customers due to its feature, where one’s investment
can be withdrawn in short period. With its investment objective to offer better return than normal
corporate deposit in the banking institutions, its appeal to the corporate sector is quite attractive.

d. Mix Fund

Mix fund is a fund that offers combination of asset classes in its investment portfolio. With the growth of the
Islamic fund industry, the demand for this type of fund has taken quite a hike. The ability to switch from an
asset class to another is a great trait of a mix fund as it can react to any economic situation seamlessly. Mix fund
can be viewed as an aggressive investment strategy to adapt to the ever-changing economic environment.

It should be noted that an investment in Islamic mutual/unit trust fund is not for particularly suitable
for investors looking for a quick return. As short-term Islamic mutual/unit trust fund is viewed as an
investment vehicle with a minimum of 3 years’ period because this type of investment product will sit
well with any investors looking for stable annual return.

44 Topic 4 Islamic Finance Architecture: Islamic Capital Market

 UNIT 3: ISSUES AND CHALLENGES IN ISLAMIC CAPITAL MARKET

Despite making great strides, Islamic capital market continues to face challenges in relation to product
innovation, development and structuring. Amongst the challenges need to be addressed are as follows:

1. Uncertainty and Disparity in the Legal, Regulatory and Tax Frameworks for Islamic Capital Market
Transactions
There is a need to address the elements of uncertainty and disparity in the legal, regulatory and tax
frameworks for Islamic capital market transactions, particularly in cross-border situations.

In this matter, country like Malaysia has established relevant frameworks that put Islamic financial
products effectively on the same playing field as their conventional counterparts. For Islamic capital
market to progress further internationally, more jurisdictions would need to move in a similar direction.

2. Competition against Conventional Counterparts

The Islamic capital market's product issuers and service providers still operate in a small
scale, especially relative to their conventional counterparts and Islamic product development
is being slow compared to conventional product development. As a result, Islamic investors
do not have as many highly liquid investment options as conventional investors do.
Product and service expansion leading to greater internationalization of the Islamic capital market will
provide a broader avenue for Islamic fund managers to expand their operations.

3. Limitations in Innovative Products of Islamic Capital Market

There were still consequent limitations in the ability of an issuer to offer a truly global Islamic product,
which in turn has implications on the issuer's product development strategy and initiatives. The lack of
product supply, especially sukuk papers, and with issuances from highly-rated issuers and sovereigns
remaining sparse, sukuk holders are holding onto securities until maturity. Investors are then unable to
purchase enough papers. These supply and demand imbalances have inhibited trading on the secondary
market for fear of not finding other papers of similar credentials and good rating to invest in. Sime Darby’s
USD1.5 billion sukuk issue in 2012 can be seen as a result of a lack of quality papers in the market as it
was oversubscribed by 10 times.

In this regard, the international Shariah advisers who sit on various Shariah boards of Islamic financial
institutions across different jurisdictions can serve to bridge the gap through constructive discussions.

4. Lack of Liquidity
Lack of liquidity has been a concern since the inception of the Islamic capital market. The behaviour
of investors, known for their predilection for buy-to-hold papers to maturity, and the lack of investor
diversity are perhaps some of the main reasons for the current deadlock in the secondary market.

Withstanding are some of the central banks’ efforts, such as the Central Bank of Bahrain and Bank Negara
Malaysia, to stimulate the growth of this market through the issuance of short term papers and the
establishment of Islamic International Liquidity Management (IILM).

Islamic capital market completes the cycle of the Islamic finance landscape, which consist of the other three
areas: Islamic banking, takaful and wealth management. It serves as a link between issuers and investors
seeking for Shariah-complaint instruments. Further development in the field of Islamic capital market;
therefore, will broaden and add further depth to the products and services and hence provide better options
to investors. Islamic capital market thus can provide a significant contribution to the overall developments
in the Islamic finance industry and eventually would assist and enable an environment of complete Islamic
finance industry to be practised.
Topic 4 Islamic Finance Architecture: Islamic Capital Market 45
 PRACTICE QUESTIONS

1. Which of the following statements are CORRECT about Islamic Capital Market?

i. Islamic Capital Market plays a vital role in attracting savings and channelling them for productive
purposes.
ii. Islamic Capital Market also plays an important role in ensuring efficient resource mobilisation and
allocation.
iii. Main Market directly affects the supply of funds for investment.
iv. ACE Market indirectly provides liquidity to the assets by providing early exit opportunity.

A. I and II
B. I, II and III
C. II, III and IV
D. I, II, III and IV

2. Sukuk market is one of the fastest growing segments of the Islamic capital market. It provide an alternative
funding avenue for corporate entities and the government, besides the bank funding. Followings are the
benefits of sukuk EXCEPT:

A. Provide avenue to source for large funding.

B. Provide liquidity to the investors as they can trade it in the secondary market.
C. Provide alternative funding avenue for corporate entities and the government, besides the bank
funding.
D. Provide risk free investment vehicle to the investors.

46 Topic 4 Islamic Finance Architecture: Islamic Capital Market

Topic 5
Islamic Finance Architecture: Islamic Wealth Management

Learning Objectives
At the end of this topic, you will be able to:
• Describe basics of Islamic financial planning and wealth management
• Describe the evolution in Islamic wealth management industry
• Describe the scope of Islamic wealth management
• Discuss the issues and challenges in Islamic wealth management

UNIT 1: INTRODUCTION TO WEALTH MANAGEMENT

Wealth management is very straightforward process. From the affluent individual’s perspective, wealth
management is simply the science of solving or enhancing his or her financial situation. From the financial
advisor’s perspective, wealth management is the ability of an advisor or advisory team to deliver a full range
of financial services and products to a client in a consultative way.

Wealth management is the consultative process of meeting the needs and wants of affluent clients by
providing the appropriate financial products and services. Wealth management entails coordinating a team
of experts to address the needs and wants of affluent clients.

Basics of Islamic Financial Planning and Wealth Management

Islamic financial planning and wealth management has been seen as a subset of Islamic finance. The process
is to look into one’s financial circumstances and then take steps to solve problems and achieve financial goals
within the compliance of Shariah. The main basis of Islamic financial planning is that wealth belongs to Allah
SWT and human beings were mere trustees.

There was a need to spur the nation’s wealth management industry in order to serve the changing needs
of the citizens and residents as the nation was migrating towards higher-income status, especially the via
Islamic financial planning and wealth management where there is a niche market.

The concept of Islamic wealth management is based on the incorporation of the Shariah rules and elements
into the process of the financial planning, whereby Shariah rules and principles will be positioned as the core
of the application of financial planning; and accordingly, Shariah will be observed, respected, and enforce
throughout the process.

In conventional wealth management, the objectives are to ensure that a person’s wealth should be able
to give as much returns as it can, without, considering the investment being invested in vehicles that gain
interest.

In Islamic wealth management; however, the main objective is to ensure that a person’s wealth is managed
in such a way that it will improve or give a much better return with the said investment using all sorts
of investment vehicles. The emphasis here is that the investment vehicles must comply with the Shariah
law in which the vehicle must avoid any investment that involves gambling, interest earning or uncertain
investment vehicles.

It is important to note that one of the objectives of financial planning is to achieve the balance between the
material and soul to fulfil the needs of both of them equally. This established concept is not against wealth
creation, but it to monitor and regulate acquiring wealth and spending according to Shariah principles. This
Topic 5 Islamic Finance Architecture: Islamic Wealth Management 47
 fundamental principle should be understood by the financial planner and the client.

Applicability of Financial Planning’s Six-Step Process in Wealth Management

Financial planning is the process of creating strategies to help clients manage their financial affairs to meet
life goals. Islamic financial planning is the process of meeting a person’s financial and non-financial goals
through a comprehensive plan that is based on Shariah rules and guidelines. Concurrently, the 6-step process
will be applied in addressing financial issues and recommending solutions to achieve financial goals.

In carrying such noble exercise, there are few aspects to be considered to ensure the comprehensive financial
plan meets the client’s requirements, business requirements and Shariah requirements as well. The following
is the 6-step process of in financial planning:

Diagram 24 : A 6-Step Process in Financial Planning

Descriptions of the above table are as follows:

1. Establish Relationship
• The client’s trust in the financial planner is of utmost importance and this will determine how much
information is revealed.
• The more details are obtained, the more accurate and relevant a financial plan can be in meeting the
client’s goals and objectives.
• The personal data that may have a financial impact on the portfolio of the client should be carefully
documented and recorded.

2. Gather information
• The financial planner should identify the problems of the client carefully and address his/her concerns.
This should include any issues that may have an impact on the financial status and eventually the
financial plan of the client.
• The financial planner should be wary of the assumptions to be used as they have a significant impact
on the final report or advice.

3. Analyze data
• This part of the process seems very similar to the conventional financial planning, but one additional
liability to be aware of is the client’s zakat liabilities.

48 Topic 5 Islamic Finance Architecture: Islamic Wealth Management

 • Understanding the movement of the funds in the client’s portfolio is important in order to have clarity
about his/her financial obligations and commitments, and to advise him/ her accordingly.

4. Develop the Plan

• The financial planner should offer financial planningrecommendations that address the client’s goals
based on the information given.
• The planner should also listen to the client’s concerns and revise the recommendations accordingly.

5. Implement the Plan

• The client and the planner should agree on how the recommendations will be carried out.
• The planner may carry out the recommendations or serve as the client’s "coach," coordinating the
whole process with him/her and other professionals such as attorneys or stockbrokers.

6. Monitor the Financial Plan

• Both the client and planner should agree on who will monitor the progress towards the goals.
• If the planner is in charge of the process, he/she should report to the client periodically to review the
situation and adjust the recommendations, if needed.

The above aspects mentioned in the process of the Islamic financial planning are by no means exhaustive
and should be practiced in the market within a high level of professionalism. Honesty, transparency and
trust must always be upheld, where the planner-advisor is always demonstrating a good code of ethics and
business conduct with high quality in performance.

Topic 5 Islamic Finance Architecture: Islamic Wealth Management 49

 UNIT 2: WEALTH MANAGEMENT EVOLUTION

Within the last decade, most firms serving high-net-worth clients have expanded their scope of services, but
the process accelerated after the stock market bubble burst and corporate scandals surfaced.

The evolutionary process from personal banking has been a beneficial one for clients. Institutions, fortunately,
have responded by providing what is needed. High-net-worth individuals and families now have access
to institutional-type investing services and a wide range of professionals to assist in all facets of financial
planning.

Wealth management firms now compete on trust and reputation and recognize the importance of fiduciary
duties to clients - a vast improvement over the early days of the business.

Conventionally, Malaysia is the first country to introduce legislation that requires a financial planner to be
licensed. Currently, there are two different types of licenses for financial planners: Securities Commission
Malaysia (SC) and Central Bank of Malaysia (BNM). The SC introduced legislation through amendments made
to the Securities Industry Act in 2003 to regulate financial planning and the use of the title or related-title
of 'Financial Planner' or to conduct activities related to financial planning. Under the Capital Markets and
Services Act 2007 (CMSA), the SC is issuing Capital Markets Services Representative’s License (CMSRL) for
individuals to be engaged in the regulated industries.

As for BNM, the amendments to the Malaysian Insurance Act require those who carry out financial advisory
business, including financial planning activities related to insurance and/or use the title of financial adviser
under their firm to obtain a license from BNM.

Evolution in Islamic Wealth Management

Compared to the conventional counterpart, Islamic wealth management is still in the infant stage development.
However, to date, the global Islamic wealth management sector is on the rise, supported by strong demand
from Muslim and non-Muslim investors.

According to UBS / PwC (2019), the latest report reveals that, more broadly, billionaires’ wealth dipped by
USD 388 billion for the first time in 2018, following five years of growth. This is due to geopolitical factors and
volatility of the stock markets in the near term. While a stock market recovery from a steep drop in late 2018
has helped wealth managers increase their assets, the world’s wealthiest families remain concerned about
global affairs from trade tensions and Brexit to populism and climate change. They are continuing to keep
more of their money in cash.

However, UBS Ultra-Rich Chief Investment Officer Simon Smiles (2019) expects most likely that billionaire
wealth will go up again this year. The potential for this increase is driven by several factors, as in Diagram 25:

Diagram 25 : Potential Excellent Growth in Islamic Wealth Management Industry

50 Topic 5 Islamic Finance Architecture: Islamic Wealth Management

Based on the above diagram 25, presently, most Islamic Financial Institutions (IFIs) are offering retail services.
Nevertheless, their involvement in Islamic wealth management is increasing. This is because as the wealth of
their clients grows, they are demanding access to private banking facilities. Apart from the above, other roles
of the IFIs engaged in Islamic wealth management include advising their clients on the advantages of placing
funds in well-regulated jurisdictions in order to reduce systemic or macro risk.

Islamic wealth management involves a variety of financial institutions; namely, Islamic banks that are regulated
by their central banks and asset and fund management companies that are regulated by institutions such
as the Securities Commission (SC) of Malaysia. A well-regulated jurisdiction will ensure a robust systems for
Shariah compliance within the institutions involved. In the case of Malaysia, there are established systems
for the appointment of Shariah scholars and regulatory vetting. For example, SC of Malaysia is undertaking
various measures to encourage the IWM industry to flourish by allowing Islamic fund management companies
to enjoy tax incentives.

Diagram 26 below summarizing the evolution of financial planning and wealth management industry in
Malaysia:

Topic 5 Islamic Finance Architecture: Islamic Wealth Management 51

 Diagram 26 : Significant Developments in Financial Planning and Wealth Management Landscape in Malaysia

52 Topic 5 Islamic Finance Architecture: Islamic Wealth Management

 UNIT 3: SCOPE OF ISLAMIC WEALTH MANAGEMENT

Technically, financial planning, as understood by the financial planning professionals, is a process of creating
strategies in managing financial affairs to meet life goals. The role of the professional financial planner is to
analyze the financial circumstances of the client and to provide a plan to meet the client’s financial needs
and goals.

The scope of Islamic financial planning includes cash flow and liability management, risk management and
takaful, zakat and tax planning, retirement planning, and Islamic estate and waqf planning, and also investment
portfolio management which involves risk management and investment planning. It corresponds to the life-
cycle of a person; from the person began earning an income until the day the person dies. It involves the
process of wealth accumulation, wealth preservation, wealth purification and wealth distribution as shown
in Diagram 27.

Diagram 27 : Scope of Islamic Wealth Management

1. Wealth Generation
Islamic wealth management would entail strategies and mechanisms to protect and develop wealth for
different segments of the population and provide a sound framework for transferring it in a Shariah-
compliant manner.

2. Wealth Protection
A key instrument of wealth and lifestyle protection is using different insurance services. The Islamic
alternative, takaful, uses principles of mutual assistance (ta’awun) and gift or donation (tabarru’) are
operating under the partnership (mudarabah) and agency (wakalah) based models. The industry has
since grown to providing protection against various types of risks to clients.

3. Wealth Accumulation
To enable Muslim clients to accumulate wealth would require availability of a range of Shariah-compliant
assets. Islamic banks provide basic banking services and various Shariah-compliant savings and investment
accounts for this purpose. The traditional assets classes include Shariah-compliant stocks, sukuk and
money market instruments. Similarly, alternative Islamic investment assets would comprise real estate/
infrastructure, commodities, private equity funds and some newly established hedge funds.

4. Wealth Purification
Zakat is a very important obligation. It is doubly important in the sense that, on the one hand, it is a
means of spiritual purification for the individual, and on the other, it is a way to regain equilibrium in
social and economic life of the entire society. zakat becomes obligatory when the wealth reaches or
exceeds the nisab.

Topic 5 Islamic Finance Architecture: Islamic Wealth Management 53

 5. Wealth Distribution
An important goal of Islamic wealth management is to preserve and plan for transference of wealth
to progeny in a Shariah-compliant manner. While the distribution of wealth among the heirs will be
determined by Islamic inheritance law, there may be a need for inheritance/estate planning to avoid
unplanned problems and ensure transfer of assets in an orderly manner. Another instrument used for
inheritance planning during contemporary times are hibah or waqf. Thus, an integral component of
Islamic wealth management relating to transferring wealth would be to provide advice and facilitate
the creation and management of waqf. Inheritance and estate planning is relatively new for the Islamic
financial sector with very few institutions offering these services.

Differences Between Islamic and Conventional Wealth Management

The financial advisor or wealth planner shall provide impartial assistance and acts in the best interest of the
client. For the Islamic financial advisor or wealth planner, the role is the same except that when the client is a
Muslim, the life goals are guided by the Shariah and the methods being applied must be Shariah-compliant.
With the above backdrop, we will now discuss the fundamental differences.

1. Time Horizon
A Muslim’s time horizon does not end upon death. Muslims believe that they will be resurrected one
day and be judged by his Creator and will continue to live in the Hereafter. This is a major tenet of
the Islamic faith. In view of this, Muslims have needs in the Hereafter and they must make sufficient
preparations while living in this world. In a conventional financial planning, there is nothing to consider
for the Hereafter. This is not a surprise at all because the conventional has no notion of the Hereafter.
It does not believe that humans will be resurrected and judged by his Creator. All their efforts are for
the life in this world, and death is the end of the conventional man’s time horizon. Thus, it is utmost
important to bear in mind that in Islamic wealth management, both the planner and the Muslims client
have to plan for, and are truly concerned of the goals and financial strategies for the Hereafter; unlike
their conventional counterparts.

2. Method
The foundation of Islamic financial planning is Shariah itself, which is a complete guide for Muslims to
live their lives in this world and for salvation in the Hereafter. A major activity in wealth management
is wealth accumulation. It is important to understand that accumulating wealth is a process. Truly, it is
quite methodological in the sense that once a method to make money is discovered, the process can be
repeated to generate more wealth. Achieving a certain amount of wealth at a certain age is a transitory
objective that leads to other objectives that are more important. A Muslim is more concerned with how
his wealth is being utilized. In this regards, a major activity that is obligatory upon the Muslims is the
payment of zakat. This wealth purification method is a distinct feature of Islamic wealth management. In
conventional financial planning, there is no such concept or requirements to purify wealth.

3. Achieving Al-Falah
To achieve al-Falah means to be successful in this world and in the Hereafter, Muslims must strive in
Allah SWT cause with his their wealth and themselves. They need to spend the wealth beyond the rate
prescribed for zakat. This is why wealth accumulation is a major concern from the Shariah perspectives.
What is being advocated is for Muslims to achieve al-Falah through sound financial planning. By going
through a financial planning process guided by Shariah, and having a Shariah compliant plan at the end, a
Muslim client can achieve al-Falah. Diligently drawing and executing a Shariah-compliant financial plan is
striving in Allah SWT cause with the wealth and the rewards being due from him. In conventional financial
planning, there is neither Allah SWT nor al-Falah to consider.

54 Topic 5 Islamic Finance Architecture: Islamic Wealth Management

Thus, Islamic wealth management is different and more comprehensive than the conventional in that:

1. the time horizon covers life in the Hereafter;

2. it is guided by Shariah in the creation, accumulation, purification, protection and distribution of wealth;
and

3. it is pursued for the sake of Allah SWT to achieve al-Falah.

Topic 5 Islamic Finance Architecture: Islamic Wealth Management 55

 UNIT 4: ISSUES AND CHALLENGES IN ISLAMIC WEALTH MANAGEMENT
Overall, the services of Islamic wealth management offered by the global Islamic financial industry are
expanding. This is evident by the increasing number of IFIs offering Islamic wealth management services.
Recent introduction of a more competitive and comprehensive product and service offerings, positive
opportunities of Islamic wealth management with Shariah-compliant, Socially Responsible Investments (SRI)
and several initiatives taken by regulators help to ensure the continued growth of the industry. However,
there are few issues and challenges that put forward some major concerns in the Islamic wealth management
market:

1. The Islamic Wealth is Presently Concentrated in Non-Muslim Countries

Despite of all advantages in Islamic wealth management, bulk of the Islamic wealth is presently
concentrated in non-Muslim countries. Due to the current challenging global macroeconomic conditions
and volatile global financial markets, there are consistent decline in oil prices. These have a taken a toll
on Islamic wealth creation globally, as most of the Muslim HNWIs originate from the oil-rich countries of
the Gulf region.

2. Experienced Islamic Finance Professionals Must Grow Faster

The provision of sound advice requires experience. Analysis must take into account both personal and
business needs that look into financial and non-financial products. To be a trusted advisor, an Islamic
financial professional be well rounded. Recognizing that a wide skill-set is required for a robust industry,
other jurisdiction has established key learning framework that is backed by global industry players for
fast tracking the development of wealth management services. Similar or better approach must be
undertaken in Malaysia, specifically for developing wealth management skills.

3. Limited Product Developments in Islamic Estate Planning

Islamic products for wealth distribution are largely undeveloped. The limited offerings available are based
on basic Fiqh concepts that are accepted under existing civil law. Conventional products are comparatively
more developed and have greater variety. For instance, the concept of trust can be applied to various
purposes such as living trusts, family trusts, education trusts, and unit trusts. A conventional trust deed
does not confine the assets settled to be Shariah- compliant. There is a need for a specific document that
functions as a trust but is Shariah-compliant. Islamic Trust Deed or Amanah Deed may provide a solution.
Such Amanah deed would ensure that the assets are settled and managed in accordance to Shariah.
Current practice requires an individual to hibah their assets prior to establishing a trust. Without doing
so, trusts created may fail as any assets not willed or given in hibah would form part of the estate to be
distributed according to faraid.

4. Developing Concepts into Viable Products

More research must be made to develop fiqh concepts into credible products that are endorsed by
the industry. An example is the concept of waqf whose properties (fixed or moveable) settled for the
benefit of waqf beneficiaries. Currently, waqf falls under the purview of state religious authorities, and
unfortunately waqf is one of the largely untapped potential in wealth distribution. Opportunities to
develop idle waqf lands to maximize revenues to beneficiaries had enhanced the attractiveness of waqf
assets as Islamic financial instruments. Utilizing waqf as potential product concept for wide arrays of
applications is still a challenge in the market.

56 Topic 5 Islamic Finance Architecture: Islamic Wealth Management

5. Lost Opportunities
Local financial institutions may only offer products developed in Malaysia or approved by regulators,
therefore limiting the creation of an attractive portfolio that takes advantage of market timing in global
markets. HNWIs which are generally highly seasoned investors and domestic service providers should
be able to offer a product suite that are comparable and competitive against the offshore banks. Locally
registered financial institutions have attained the competency level by offering global products, and are
better placed to advise domestic HNWI on their portfolio.

What is next?

Moving forward, various steps have to be taken by the global Islamic financial industry to take on this new
phase of development. These include, firstly; offering a variety of innovative and sophisticated products
which include Shariah-compliant SRI to meet the more sophisticated demands of the increasingly affluent
Muslims investment population.

Secondly, whilst wealth managers are able to address the issue of wealth enhancement, protection and
distribution, and existing services need to be further developed to allow for more customization and
opportunity for returns enhancement in all economic and investment cycle. Thirdly, to continuously develop
wealth management skills for the advisor. This is because to provide sound advice to the clients, an advisor
must take into account both personal and business needs by looking at both financial and non-financial
products. In other words, advisor should be well-rounded.

Finally, to increase public awareness on Islamic wealth management as there seems to be lack of awareness
among the public about Islamic wealth management. To serve this purpose, in Malaysia, the Malaysia
International Islamic Financial Centre (MIFC) Community, which serve the Malaysia's Islamic finance
marketplace, has been founded on the launch of the MIFC initiative in 2006.

Topic 5 Islamic Finance Architecture: Islamic Wealth Management 57

 PRACTICE QUESTIONS

1. Which of the followings are CORRECT about Islamic Wealth Management?

i. Wealth Management is an ibadah

ii. Wealth is an amanah from Allah SWT
iii. Wealth is a major means to achieve al-Falah
iv. Islamic Wealth Management must be guided by Shariah principles

A. I and II
B. I, II and III
C. I, II and IV
D. I, II, III and IV

2. Which of the followings are components of Islamic Wealth Management?

i. Wealth Generation
ii. Wealth Accumulation
iii. Wealth Protection
iv. Wealth Purification

A. I and II
B. I, II and III
C. I, II and IV
D. I, II, III and IV

58 Topic 5 Islamic Finance Architecture: Islamic Wealth Management

ANSWERS

AQIF M1 AQIF M2 AQIF M3 AQIF M4 AQIF M5

Topic 1 Topic 1 Topic 1 Topic 1 Topic 1
1. D 1. A 1. B 1. C 1. D
2. A 2. B 2. B
Topic 2 Topic 2
Topic 2 Topic 2 Topic 2 1. D 1. D
1. D 1. D 1. D 2. D 2. D
2. C 2. A 2. C
3. B Topic 3 Topic 3
Topic 3 4. A Topic 3 1. D 1. D
1. B 5. B 1. C2. C 2. C 2. B
2. C 6. D
Topic 4 Topic 4 Topic 4
Topic 4 1. A 1. D 1. D
1. C 2. C 2. B 2. D
2. C
Topic 5
Topic 5 1. D
1. D 2. D

Topic 5 Islamic Finance Architecture: Islamic Wealth Management 59

 GLOSSARY

Gharar Uncertainty that might lead to destruction and loss

Islamic Banking A banking system that is based on Shariah law, and guided by Islamic
economics. Two basic principles behind Islamic banking are the sharing
of profit and loss and, significantly, the prohibition of the collection and
payment of interest by lenders and investors. Collecting interest or "riba"
is not permitted under the Shariah law

Islamic Capital Market A markets for buying and selling equity and debt instruments whereby the
transactions are carried out in ways that do not conflict with the conscience
of Muslims and the religion of Islam. Here, there is assertion of Shariah
law so that the market is free from activities prohibited by Islam such as
usury (riba), gambling (maysir) and ambiguity (gharar)

Islamic Finance Refers to the means by which corporations in the Muslim world, including
banks and other lending/financial institutions, raise capital in
accordance with Shariah. It also refers to the types of investments that
are permissible under this form of law. A unique form of socially responsible
investment, Islam makes no division between the spiritual and the secular,
hence its reach into the domain of financial matters

Islamic Wealth A high-level professional service that is accordance to the Shariah law,
Management and guided by Islamic economics that combines financial and investment
advice, accounting and tax services, retirement planning and legal or estate
planning for one set fee. Clients work with a single wealth manager who
coordinates input from financial experts and can include coordinating
advice from the client's own attorney, accountants and insurance agent. Some
wealth managers also provide banking services or advice on philanthropic
activities

Maqasid Shariah Objectives of Shariah

Maysir Gambling

Mu‘amalat Any form of mutual dealing held between man to solve their everyday
needs, especially in the matters relating to trade and commerce

Private placement A method to raise small amount of capital (circa below USD50 millions)
and normally only offered to selected investment firms or individuals.

Publicly issued A method to raise big amount of capital (above USD50 millions) and of-
fered to public.

Retakaful A Takaful effected with another Takaful operator(s) to enable a Takaful op-
erator to expand its capacity; stabilise its underwriting results; finance
its expanding volume; secure catastrophe protection against shock losses;
withdraw from a line of business or a geographical area within a specified time
period

60 GLOSSARY
Riba Interest, increase, addition or growth, though it is usually translated as 'usury'

Shariah Islamic Law / Jurisprudence. Islamic law is derived from the sources of the Qu-
ran, Sunnah, Ijma and Qias

Sukuk An Islamic financial certificate, similar to a bond in Western finance, that

complies with Shariah law. Since the traditional Western interest-pay-
ing bond structure is not permissible, the issuer of a sukuk sells an inves-
tor group a certificate, and then uses the proceeds to purchase an asset,
of which the investor group has partial ownership. The issuer must also
make a contractual promise to buy back the bond at a future date at par
value

Tabarru’ Donation or charity. A contract where a participant agrees to donate a

pre-determined percentage of his contribution (to a Takaful fund) to provide
assistance to fellow participants. In this way, he fills his obligation of joint
guarantee and mutual help should another participant suffer a loss. This
concept eliminates the element of gharar from the Takaful contract

Takaful Joint guarantee or guaranteeing each other. It stems from the word kafal or
to take care of one’s needs. Takaful is a system of Islamic Insurance based
on the principle of ta’awun (mutual cooperation) and tabarru’ (donation)

Takaful Participant The individuals (or institutions) who enter into a Shariah-compliant
scheme of mutual risk cover

GLOSSARY 61