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The Actuary The magazine of the Institute & Faculty of Actuaries
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Ethical investment AD650

Ethical investment has found a niche in the financial services market. A niche within the niche belongs to Islamic investment, a 1,500-year-old (but still evolving) principle sharing many features with its agnostic or Christian counterparts.
Some of the similarities might be apparent no immoral earnings and no investment in arms companies. Usury was spoken against in the New Testament, while more recent 19th-century writers have attacked the practice. Victorian Protestant entrepreneurs might recognise Islamic investment.

Points of interest
The primary difference relates to interest payments. Unearned exploitative income is condemned in the strongest terms in Islam and this condemnation usually extends to risk-free interest. The point is made explicit in the English translation from Arabic of the unacceptable riba as ‘interest’. At the time the rules of the Koran were formulated, money-lending at extortionate rates was widely practised on the Arabian peninsula. The two concepts of interest and usury were similar, with the poor suffering severely under them. Speculation and gambling were also perceived to have harmful effects, and were outlawed.
The circumstances then were very different from today’s, but the fundamentals still hold for Muslims. These fundamentals have been adapted to the modern financial world, from options markets, monetary expansion, and intermediaries, to the splitting of assets into risk-free and risk-carrying parts.
Islamic investment is not widely practised, even in the Muslim world. The global economic predominance of the western system and interlocking economies makes it difficult for one state to unilaterally declare its adherence to such a system. Saudi Arabia and Iran have made attempts to introduce Islamic values into the financial sector, but the most determined measures, including the establishment of a stock exchange, have been introduced in the Sudan, although even progress here has been uncertain. Other states with large Muslim populations often have some private or state provision. The prize for imagination must go to the Eritrean government. Knowing Muslims are opposed to unearned interest, it offered its treasury bonds to Christian investors with interest payable and to Muslim investors without interest. The same principle was repaid to both. This may be considered as a zero-return loan that the Koran exhorts Muslims to make to those in need.

Insurance matters
In insurance, only half the story is told by the premiums and losses, with the purchased investments critical for the profits of the insurer, security of the insured, and demand in modern asset markets. Islam’s guidance on investments brings challenges to the well-known ideas regarding suitability of assets. For example, a general insurer may write volatile short-term business and consequently be highly risk-averse in its choice of investments. Without buying a fixed-interest portfolio, the choices for appropriate assets are somewhat constrained. Certainly holding non-interest-bearing cash deposits is very low risk, but then profits or premiums would be adversely affected by low returns. Reinsurance looks far more attractive in this setting. A full analysis, using tools like immunisation, could be undertaken subject to constraints on acceptable asset classes, in the same way as market imperfection adjustments are made when implementing capital asset-pricing models.

Size and scale
The total assets under management according to Islamic principles are assessed to be $200bn to $300bn, roughly the size of the capital stock of South Africa. Islamic financial institutions in their modern form were established widely only after the oil price rises of the 1970s, while the current period of worldwide growth (at an estimated 10% per year) dates back a decade or so. Many of the major western banks are starting to participate in the market, including Citibank, HSBC, and BNP Paribas.
The ijara loans for house purchase, offered by the United Bank of Kuwait, have been sold in the UK for several years, with around 30 purchased each month. Under ijara, a bank buys a house for an individual, who repays the cost of the house by constant amounts over a fixed term. During the term, the bank makes profit by charging a variable, market-based rent on the share of the house not yet purchased by the individual.
Considering Islamic investment alongside wider ethical investment principles demonstrates that some parts of its approach are common to western methods. More thorough challenges are presented by the prohibition of interest and the condemnation of exploitation. Interest payments are core to debt-based economic growth. Under Islamic principles, the risk characteristics of an insurance or investment market would change, with a shift from some low-risk assets and perhaps a larger degree of risk pooling. In a pensions context, gilts seem well suited to a maturing, underfunded sector. Finding a second-best asset would be difficult, although an extensive Islamic financial system would lessen the need to match against fixed-interest liabilities, since profit and loss sharing is central to the economy on both supply and demand sides.

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