The Gift Exchange Anomaly: Takaful Operator Incentives

How do incentives affect the performance of Islamic insurance operators? This is the question that the article “Gift exchange anomaly: evidence from incentives vis-à-vis performance of Islamic insurance operators” by H.Khan (2015) answers using standard field data.

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What is a gift exchange anomaly?

Gift exchange anomaly is a term used to describe a phenomenon observed in some experiments, where agents (workers) respond not only to the piece rate of the incentives but also to the wage of the incentives. This means that agents are willing to exert more effort if they receive a higher wage, even if the wage is independent of their performance. This behaviour contradicts the standard models of optimal incentives, which assume that agents are only motivated by the marginal benefit of their effort.

Why is gift exchange anomaly relevant for takaful operators?

Participants (in takaful policyholders are known as participants) hire takaful operators (TOs) to manage the takaful fund, which is a pool of contributions or donations collected from participants who insure each other. TOs receive compensation based on either or combination of these contracts: wakalah (agency), mudarabah (profit-sharing), and surplus-sharing.

Wakalah is a fixed upfront fee that TOs receive as a percentage of contributions. Mudarabah is a share of the investment income.

Surplus-sharing is a share of the risk fund surplus, which is the difference between contributions and claims.

The article argues that the compensation scheme of TOs can be seen as a form of gift exchange between participants and TOs. The Participants' offer a generous wage (wakalah fee) to TOs, expecting them to reciprocate by providing high-quality service and minimizing the operational costs and losses. TOs, in turn, may feel obliged to meet the expectations of the participants' and perform better than the minimum required by the contract.

What does the article find?

The article uses an unbalanced panel of 174 observations from 30 TOs in the GCC, Pakistan, and Malaysia, covering the period from 2003 to 2011. The article measures the performance of TOs using four variables: insurance profit (IP), expense ratio (ER), loss ratio (LR), and combined operating ratio (COR). The article regresses these variables on the incentives offered to TOs, controlling for macroeconomic factors and panel effects.

The article finds strong evidence in favor of the gift exchange anomaly. The wakalah fee has an inverted U-shaped relationship with IP and a U-shaped relationship with ER, LR, and COR. This means that there is an optimal level of wakalah fee that maximizes the performance of TOs, and that too high or too low wakalah fee can have adverse effects. The article estimates that the optimal wakalah fee is around 54% of the net earned premium.

The article also finds that the profit-sharing incentive (mudarabah) has either an insignificant or a negative impact on the performance of TOs. This suggests that mudarabah does not provide a strong incentive for TOs to invest the fund efficiently.

The surplus-sharing incentive, on the other hand, has a large and significantly positive impact on the performance of TOs, especially on the ER. This implies that surplus-sharing aligns the interests of participants' and TOs, and encourages TOs to reduce the operational costs and losses. (However, it has to be keep in mind that most shariah scholars do not allow surplus sharing between TO and participants as this surplus cannot be considered as profit)

What are the implications of the article?

The article has important implications for the design of optimal contracts between participants and TOs. The article shows that wakalah-surplus sharing hybrids outperform any other hybrid of the principal contracts, and that mudarabah should not be offered as a hybrid.

The article provides evidence on the gift exchange anomaly using standard field data on the performance of takaful operators. The article finds that the wakalah fee has an optimal level that maximizes the performance of TOs, and that the surplus-sharing incentive has a positive impact on the performance of TOs. The article also finds that the profit-sharing incentive has either an insignificant or a negative impact on the performance of TOs. The article has important implications for the design of optimal contracts between policyholders and TOs, and recommends the wakalah-surplus sharing model as the best choice.

Here are the main points to remember:

• Gift exchange anomaly is a phenomenon where agents respond not only to the slope, but also to the intercept of the incentives.
• Takaful operators receive a compensation that is determined by a hybrid of three principal contracts: wakalah, mudarabah, and surplus-sharing.
• The article uses an unbalanced panel of 174 observations from 30 TOs in the GCC, Pakistan, and Malaysia, covering the period from 2003 to 2011.
• The article finds that the wakalah fee has an optimal level that maximizes the performance of TOs, and that the surplus-sharing incentive has a positive impact on the performance of TOs.
• The article also finds that the profit-sharing incentive has either an insignificant or a negative impact on the performance of TOs.
• The article recommends the wakalah-surplus sharing model as the best choice for policyholders and TOs.

P.S. What do you think of the article and its findings? Do you agree or disagree with the implications for the takaful industry? Share your thoughts in the comments below.

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

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