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Risk Management In Islamic Finance
by Ebrahim Patel

The element of risk is present in all of life’s activities, be it the simple decision to drive to work or a complex series of life changing decisions. The most obvious way of dealing with the risk inherent in most activities is not to undertake the activity at all. But, no one does this. Why? Because there is an element of utility, a rewarding outcome, associated with each activity, in addition to the inherent risks. Most activities that have risk also have rewards and being able to understand the relationship between risk and reward for a particular action or choice will help guide a person toward the appropriate action. For example, is the reward to be gained so great that a person is willing to expose himself to great risk, or is the reward so minor in comparison to the risk that the person would rather forfeit the reward? Unfortunately, the rewards offered by most activities are necessary for normal living and as such, we have no choice but to assume risk. It is therefore clear that we should be seeking ways to either eliminate risk, or manage it so that the probability of a risk event occurring is minimized, or that the consequences of a risk event taking place are minimized.

Financial transactions offer the promise of rewards which attract corresponding risks. Trade in physical assets, service businesses, any type of commercial activities attract risk. The basic premise behind Islamic Finance is the aspect of risk sharing in financing transactions, and the prohibition of trading in paper assets. The significance of this will become clearer when contrasted with the manner in which risk is dealt with in conventional financial transactions. Risks that arise in the “physical” world, such as uncertain future prices for commodities, rising costs, inflation, risk of destruction, etc. are often transferred to the financial markets, and transferred via paper assets, such as derivative instruments, to parties willing to assume the risk, in the hope of profiting from the non-occurrence of risk events. Conventional insurance relies heavily on investing funds in paper assets to help grow funds in order to meet expected claims. In addition, insurance companies further transfer elements of their risks using instruments such as weather derivatives and insurance derivatives. Companies exposed to the risk of changing interest rates, uncertain inflation, etc. can use instruments such as inflation linked notes and interest rate swaps. Currency risk can be hedged using forward exchange contracts, etc.

As mentioned early, Islamic Finance emphasizes the assumption of risk for every reward to be gained. The concept of a risk-reward scale is thus not foreign to Islamic Finance, in fact, it is the basis of it. It follows from this that the making of a risk free profit in Islamic Finance is very difficult, if not practically impossible. The emphasis in Islamic Finance is thus toward risk management, as opposed to trying to make risk free profits. Since Islamic Finance prohibits trading in paper assets, it follows that risk management would require the use of real assets and the application of non-financial risk management techniques. The array of risks that are faced in a commercial environment are vast, and as such, this article will focus on a few common risks, in order to highlight the principles that can be applied to risk management in Islamic Finance.

The asset with potentially the lowest risk profile in Islamic Finance is physical property. The rental cashflows resemble those of a bond, allowing for the ability to match regular, stable liabilities with expected income. The stable nature of property investment, in comparison to normal cyclical business activities, offers opportunities to smooth certain business risks.

Let’s take the case of an equipment rental company. The company wishes to lease out capital equipment to customers, and thus intends to turn a profit from the lease premiums received (an Ijaarah contract). Assume that the company requires R10 million worth of equipment in order for the business to be viable. Further assume that the company does not require a loan to acquire this equipment. Typically, the risk that this company faces is the destruction of its equipment. The owner of the company can approach an investor to propose a property investment scheme. The entrepreneur could identify a property with profit making potential, and approach an investor to co-invest with him. The company invests an amount, say, R10 million and the investor invests R20 million. The agreement is that all rental income is for the benefit of the company, and all capital profits on disposal of the building is for the investor. The property recognizes an operating rental yield of 12% before tax. The company then purchases the equipment on an installment basis over 10 years. In order to finance the equipment, the company goes to an Islamic Financier who purchases the equipment for R10 million and sells it back to the company for R20 million payable over 10 years. The company thus receives R3,6 million p.a. in property rental income before tax(assume the company charges the property owning entity a management fee equal to operating rental income, for example), and has to pay R2 million p.a. toward paying off the equipment. The company is left with R1,1 million in cash after accounting for tax, depreciation(assuming a 10% straight line depreciation allowance) and payment of installments on equipment from after tax money. The table below summarizes the transaction thus far.

Assume that the replacement cost of equipment increases by 8% p.a. over a 10-year period. The following table illustrates the replacement costs in years 1 – 10, and the proportion of equipment that can be replaced out of surplus cash as calculated above. It is assumed that rental also increases by 8% p.a.

Cash After Installments
Replacement Cost of Equipment
% of Equipment Replaceable Every Year
% of Equipment Replaceable Assuming no Prior Replacement

We can see that the cumulative replacement ratio rises every year assuming that none of the surplus cash is used in the prior year. Lets further assume that the liability for destruction of the equipment is transferred to the lessee, by mutual agreement. Assume for simplicity, that in any one year, 70% of the equipment value is in the hands of the lessee. Assume that only 40% of lessees have the financial ability to replace the asset at replacement value, and 30% can repay half the replacement value, meaning approximately 55% of the value in the hands of the lessees can be recovered. What are the replacement values under this scenario?

% of Equipment Replaceable Assuming no Prior Replacement
% of Equipment Replaceable Every Year

We can see that transferring legal liability for asset replacement to the lessee greatly improves the percentage of the company’s equipment that is replaceable annually. The company can improve these figures further by working to increase the % of equipment in the hands of lessees in any given period and by only leasing equipment to clients that can financially afford the cost of replacing assets. Thus, the company has used a financial risk mitigation scheme, investing in real assets as a base cover, and then attempting to use non-financial measures to achieve greater risk coverage (by choosing financially able lessees and aiming for 100% of equipment to be leased at any time).

Compared to conventional insurance, there are a number of differences. The amount of equipment covered is not a guaranteed 100%, but will depend on asset utilization, the performance of the property rental investment and the credit worthiness of lessees. Thus, there is no certainty of full coverage as afforded by conventional insurance. However, should there be no significant risk events, the company has accumulated cash on it’s balance sheet to re-invest, etc. whereas conventional insurance premiums would be lost. Therefore, by adopting a Shariah compliant form of risk management, the company has to work harder to achieve 100% risk cover, but has the advantage of retaining the cash it has put aside toward risk mitigation. Remember, that our analysis does not take into account lease premiums earned from leasing out the assets themselves, and if the company has pricing power, a portion of these receipts could be retained as after tax cash to further offset risk. Another risk that is covered by this scheme is the paying off of the equipment from rental receipts while protecting the initial capital.

After the ten-year period, the property is sold leaving the investor with a return equivalent to approximately 14% p.a. after tax.

The company gets it’s original R10 million investment back on sale of the property, and depending on the risk events in the past 10 years the company will have between R10 million and R26,5 million in cash(an after tax, after capital repayment return of 5% p.a.). The use of the investors money to add “leverage” to the company’s rental income and the use of the company’s money to add “leverage” to the investors capital gain provides the incentive for both entities to enter into this transaction. The company needs capital protection with regular income, and the investor needs capital protection but can wait for returns.

The possibilities for using a combination of financial, legal and operational transactions to hedge risks forms the basis of a hedging strategy in Islamic Finance. Commodities such as gold can be used to hedge forex risk, etc. The potential combinations are endless and will surely provide fertile ground for future research.

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