Takaful – Islamic insuranceINTRODUCTIONHuman beings have long recognised the need to protect themselvesagainst the impact of risks they face, such as natural disasters, travelaccidents, unemployment, sickness or dying at a young age and leaving avulnerable young family behind.Islam teaches its followers to put their trust in God; at thesame time, it also encourages them to use the resources, skills and abilitiesbestowed on them by God to act responsibly and protect their wealth andproperty.In this chapter we will look at the reasons why conventionalproprietary insurance is not regarded as sharia-compliant andexplore the Islamic alternative called takaful.SHARIA PERSPECTIVE ON CONVENTIONALINSURANCEIn conventional proprietary insurance schemes, a commercialentity seeks to provide insurance cover for a particular risk by charging aninsurance premium and make a profit net of any claims and other costs.
Thismodel is at odds with the sharia in three key respects:Gharar (excessiveuncertainty)Insurance aims to provide protection against an event that couldhappen but is uncertain in terms of if or when it might happen. Actuaries modelthe probability of events occurring and seek to set insurance premiums at alevel that both compete effectively in the market and maximise profit for theinsurance company. These attempts to model the future will invariably beimperfect.
Some unreliability will exist in almost all commercial dealings (forexample, when a consumer buys fruit, there is a chance that it will not befully grown). This level of uncertainty is seen as natural and accepted in themarket. However, the sharia does not tolerate ‘excessive’levels of uncertainty (gharar) and most scholars are of the opinion thatthe uncertainty found in commercial insurance contracts falls into thiscategory.Maysir (betting)Related to the fact that the occurrence of certain events isuncertain, sharia scholars are generally of the opinion thatthe premium charged by commercial insurance companies is similar to placing abet (maysir) on whether a particular event will happen. So this isanother sharia objection to conventional proprietaryinsurance.Riba In conventional insurance schemes, either the policy holder willreceive more than they pay as a premium (if a successful claim is made) or theinsurance company will receive more in premiums than it pays out in claims.Given that the ultimate outcome is a money-for-money exchange, i.
e. a premiumpaid in money is exchanged for a potential payout in money later, and thatthese two values will invariably be different, in a commercial context thiswould amount to riba. Riba can also arise if theinsurance company invests in interest-bearing instruments such as gilts.TAKAFUL – THE ISLAMIC ALTERNATIVETakaful means mutual cooperation or jointguarantee. It refers to a not-for-profit set-up in which individuals clubtogether by contributing into a common pool. The monies in this fund are usedto pay out to members of the pool who have been afflicted by certain eventsthat the members have mutually agreed to cover each other for – travel accidents,for example. The monies left in the pool after paying claims belong to themembers.
The Takaful Act enacted by Malaysia in 1984 defines takaful asfollows:A scheme based on brotherhood, solidarity and mutual assistance,which provides for mutual financial aid and assistance to the participants incase of need whereby the participants mutually agree to contribute for thepurpose.The sharia violations of riba, gharar and maysir thatare prevalent in conventional commercial insurance contracts do not occur insuch a system. Instead of a premium payable in a commercial insurance contract,pool members donate (tabarru means donation) a sum of money to thepool. If a member is paid compensation from the pool, this payment is regardedas a form of mutual assistance rather than as a countervalue paid under acontract of exchange.
Hence the issue of riba does not arisein such a system.Similarly, the non-commercial nature of the arrangement meansthat the prohibitions of gharar and maysir donot apply. It is in a commercial context that the sharia demandsas much certainty as possible in the exchange between the two parties to atransaction (i.e. absence of gharar) and forbids gambling/betting (maysir)by either party.
Takaful is different from commercial proprietaryinsurance with regard to who bears the risk. In commercial proprietaryinsurance the risk is transferred to the insurance company, which takes on therisk(s) covered in the insurance policy in exchange for the insurance premium.Under the takaful system, risk is not directly transferred to anythird party but is borne by and distributed among the members of the pool.The relationship between the pool members and the pool is framedin terms of two binding promises: the members promise to contribute to thefund, and the pool promises to pay out in the event of a claim.The takaful system is virtually similar to the conceptof mutual insurance, which is still alive today and has a deep heritage in theUnited Kingdom, rooted in local communities putting money into a common pool toprotect members from certain mishaps.
It is worth noting at this point that in markets such as theUnited Kingdom, the provision of takaful products is limited. Wherethe law demands protection (for example, car insurance is required to drive acar in the United Kingdom) and there is no sharia-compliantalternative available, scholars have permitted the use of conventionalinsurance products. This is based on the fact that it is a legal requirement ofthe country and Islamically it is of paramount importance to be law abiding andmaintain social order and harmony in society. Where there is no legalimperative but there is no sharia-compliant alternative available,scholars are reluctant to grant the use of conventional insurance products, butit depends on the circumstances of a particular case, may endorse it if it isdeemed that the potential loss to the person/entity will be very hard torecover from. takaful MODELStakaful could in theory be embed byadministratives or by privately organised groups. In real, given the range ofrisks that requires covering and the fact that different risks apply todifferent groups of people, it is difficult for system to provide thecompulsory range and depth of coverage. Therefore takaful solutionshave tended to be set by private organisations.
Singleentity structureA single non-profit body can be set up on a mutual or communalbasis. This is almost similar to a mutual organisation in the United Kingdom,in which the entity is owned by members and there are no external shareholdersseeking to make a profit from its activities. Members appoint a board ormanagement to run the operation. The cost of management and other expenses arefunded through member contributions and other activities such as profits earnedfrom investments. Any excess, net of claims paid and expenses, belongs tomembers.
Any shortfall needs to be covered by increased contributions from associates.Doubleentity structure A two-tierstructure of takaful operation is:· Entity 1: a takaful mutualfund/pool operating on a non-profit basis to collate members’ funds and pay outto them on the incidence of certain events covered by the fund. The monies inthe pool, including any surplus, belong to the members.· Entity 2: a commercial entity,usually referred to as the takaful operator , engaged bythe takaful fund to manage activities such as claims handlingand investments in accordance with sharia principles. Thecommercial entity is motivated by the revenues it can earn for shareholdersfrom services provided to the takaful non-profit-makingentity.
The TO has no direct liability in respect of any takaful policiesissued by the fund – it is merely entrusted to manage the takafulentityand its investments.A common feature of the relationship between the TO andthe takaful fund is that the operator agrees to provide aninterest-free loan to the fund in the event of a shortfall in the funddue to claims exceeding member contributions.Possible pitfalls of the double entity structureMost takaful operations around the world havebeen set up based on the double entity structure, and have usually beeninitiated by takaful operators who have identified a commercialopportunity in providing sharia-compliant protection.There are some potential pitfalls with this structure:1. takaful isin essence a non-profit-making activity, set up for the mutual protection andbenefit of its members. The takaful fund must ensure that itsoriginal purpose and values are not undermined by the involvement of acommercial entity focused on maximising profit.
Close attention needs to bepaid to how the commercial entity is remunerated, so that its interests arefully aligned to those of the takaful fund. We will look atthis more closely when discussing how the relationship between the TO andthe takaful fund can be structured.2. Somecommentators have argued that the agreement by the TO to provide aninterest-free loan to the takaful fund in the event of ashortfall is tantamount to transferring risk from the takaful fundto the TO. Such a transfer would be fundamentally at odds with the conceptof takaful – that risk needs to be shared and distributedamong members of the takaful fund and not transferred to athird party.Relationshipbetween the takaful pool and the takaful operatorAs described above, the operator provides services to the pool.
These services fall into two broad categories:1. Underwriting –this includes issuing new takaful policies and claimshandling. These services are typically provided by the operator to the poolthrough a wakala contract (principal–agent relationship).
Theoperator acts as the agent (wakil) of the pool members (the principal)and receives a fee for its underwriting services on this basis. This can bestructured as a fixed fee or as a percentage of the contributions paid into thepool.2. Investmentmanagement – this refers to investing the monies of the takaful poolon behalf of the pool members.
A mudarabah contract for theinvestment management services is typically provided by the operator. Theoperator acts as the mudarib, providing investment managementservices to the pool members, who collectively form the rabb-ul-maal (providersof capital). Under such a contract, the operator does not receive any fixedremuneration, instead sharing in any profit generated through the investmentactivity, while any losses are borne solely by pool members.
The wakala contract for underwriting servicesand the mudarabah contract for investment management servicesis the most common model used to define the relationship between the TO andthe takaful pool and its members. There are a number ofreasons for this:· The wakala contract lends itself well to theprovision of underwriting services as a management fee is charged to the poolby the TO. This is usually either a fixed fee or a percentage of the value ofcontributions received by the pool (this can be justified on the basis that thegreater the value of contributions, the more work the operator needs to do).· Applying a mudarabah (profit-sharing) contractto underwriting would not work as well for the following reasons:· The essence of takaful is that any underwritingsurplus should belong to the pool members, as they are and should be the ‘risktakers’. If the operator shares in the surplus, its role as a ‘risk manager’starts to merge wrongly into ‘risk taking’.
· An underwriting surplus is not the aim of the takaful pooland is not the same as a profit – it is in fact an undistributed surplus fromthe tabarru. Hence to apply a contract of profit sharing issomething of a mis-fit.· Similarly, if the operator is remunerated according to the valueof the underwriting surplus, the operator will be motivated to maximise thesurplus. This is not aligned to the interests of the pool members, nor is itcompatible with the aims and values of takaful.Yet the mudarabah contract is well suited tothe investment management activities of the TO. The operator receives a share ofany profits from the investments and hence the operator’s interests aregenerally aligned to those of the pool members – to make the best possiblereturn.
However, there is the potential misalignment of interests if theoperator wants to take more risk than is suitable for the pool members. Suchissues need to be addressed in the governance applied to takaful operations.Nevertheless, it is also possible to use a wakala contractfor investment management services, instead of the mudarabah contract.The fee payable to the operator (wakil) can be structured to contain aperformance-related component.
The mudarabah contract isgenerally more risky from the operator’s point of view as no remuneration willbe received unless a profit is made on the investments. Hence either wakala or mudarabah contractscould be used for investment management services: the contract chosen dependson the preferences of, and agreements between, the TO and the pool members.Use of the waqf (endowment)concept in takafulA waqf isan inheritance created by a person who donates an asset that they own to anendowment vehicle, with the intention of benefiting specified beneficiaries.The benefactor can still manage the holding or may pass managementresponsibility to other specified members.
In the United Kingdom and otherjurisdictions, where specific waqf prescriptiondoes not exist, trusts can work well similar to endowment vehicle.In the takaful arena,the use of the waqf concept has been increasingly applied. InPakistan, for example, a waqf takaful modelhas been used. The waqf founder initiates a takaful operation by dowering a sum of money tothe waqf. Contributors then participates to the waqf withthe objective of giving out and helping participants who are affected byspecified events, risks or disasters.In this type of scheme, all dowry returns and anyunderwriting surplus remain within the waqf andare not shared with the donators. The participants at the outset agree that anysurplus should be kept and used by the charitable waqf.A waqf may appoint external providers to supplyservices such as investment management.
A more common model is to combine a waqf witha wakala contract, and in some circumstances with mudarabah as well. For example: A takaful manager provides underwriting services on a wakala basis. The operator also provides speculation management services on a mudarabah basis. Any spare generated by the takaful pool is donated to a waqf, instead of being redistributed back to contributors.Using a waqf inthis way can help to reduce a practical issue of redistributing surpluses backto contributors. Insurance is a dynamic activity with a continuous stream of beginnersand leavers and new claims. Moreover, claims can sometimes be made someconsiderable time after the incident giving rise to the claim has occurred.
Asa result, accurately ascertaining what proportion of the surplus a member isentitled to can be difficult. This issue is resolved if all contributors agreethat any excessive should be paid to a charitable waqf. TYPES OF TAKAFUL POLICY Conventional insurance is broadly divided into lifeinsurance and general insurance. In a similar way, takaful can be broadly categorised into general andfamily/life takaful.General takaful:General takaful,like general insurance, seeks to provide accidental coverage suffered by replacing value equivalent to thatprior to the damage or loss. The risks covered are generally short-term innature, such as protection against car accidents, travel problems, fire, damageto property and so on. Within this space, protection for businesses such asprofessional indemnity, employer liability and public liability cover are allpossible.
General takaful policies usually last one year and focus almostentirely on protection as opposed to investment return and growth. Hence theactivities of the TO or the mutual takaful poolare centred around underwriting.Family/life takaful:Takaful can cater for all risks, including death – toprovide intervention to the family of the deceased is very much in line withIslamic values. Family/life takaful plansare generally schemes that provide coverage to a person wishes to save a sum ofmoney for dependants, should the participant die prematurely. This cover iseffectively a long-term savings plan, typically of 10–30 years duration. Giventhe long-term savings nature of these policies, contributions by participantsare usually split into an underwriting pool and an investment pool.
If theparticipant dies during this period, the policy provides some financialprotection for the family and dependants left behind; otherwise the policymatures at the end of the contracted period.Such policies can also usually be redeemed at any timeup to maturity. Family/life takaful thereforegoes beyond simply insuring against the event of death; it also enables theparticipant to save a capital sum on survival.There are three typical scenarios:1. Deathbefore plan matures: heirs to the affected’s estate receiveall of the monies accumulated in the investment pool based on the deceased’scontributions into the pool and the returns earned on those contributions. Inaddition, the heirs will receive from the underwriting pool an amount of moneyequivalent to all remaining or outstanding total donations that would have beenmade if the participant had survived until maturity of the takaful plan.2. Benefitsat maturity: if the participant survives untilmaturity of the plan, he or she will typically receive the monies accumulatedin the investment pool (as above) plus a proportion of the excess, if any,arising in the underwriting pool.
3. Surrenderbenefit: this arises when a participant decidesto end his policy before maturity. Typically he or she receives moniesaccumulated in the investment pool on his behalf, but does not receive anymonies from the underwriting pool.It is possible to provide takaful such that a person’s family receives a payout ondeath, whenever that occurs. This is rare because life cover is invariably along-term policy; in takaful, the hard cash in the pool belong to the members andhence this is suited to a plan in which the member benefits from investment andspeculation.EXAMPLETakafulMalaysia is a leading takaful provider in Malaysia. Itprovides both family and general takaful products.
On thefamily side it provides protection for health problems (paying for medicalfees, etc.), protection against the risk of not being able to pay for homefinance payments, and protection against death before a certain age. On the general takaful sideit offers protection against fire, damage to property, motor accidents andpersonal injury, and a multitude of protection products forbusinesses/organisations.
RetakafulAs with conventional insurance, the takaful pool needs to be able to redistribute some ofthe risk outside the pool if it is to remain viable and sustainable. Otherwise,very large claims resulting from catastrophic events (such as heavy storms orflooding) could cause the pool to become insolvent. Consequently, retakaful has developed in a similar way to reinsurance.
The takaful poolredistributes some of the risk in the pool by passing a portion of thecontributions in the takaful pool to the retakaful pool. The retakaful poolworks on the same principles as takaful:the members of the retakaful pool (other takaful pools/funds) make contributions into the pool tomutually guarantee each other. The participants in a retakaful contract are the takafuloperators, acting on behalf of the respective takaful pools they represent. THE FUTURE OF THE TAKAFUL INDUSTRYA report by Ernst & Young in 20131 commentedthat ‘there is a dearth of takaful operatorswho are capable of providing leadership to the growing internationalisation ofthe industry. There is a need for large, regional champions to lead growth inregional markets and to participate in international markets’.There are signs of change. In this 2013 publication,Ernst & Young reported that global gross takafulcontributions are estimated to be around $15 billionin 2014, growing at more than 15 per cent per annum.
Momentum seems to be building in takaful’s three key markets – Saudi Arabia, Malaysia and UAE.Saudi Arabia accounts for approximately half of the Islamic insurance industry,partly due to the fact that conventional proprietary insurance is not permittedin the country. The growth lever for strong growth in Saudi Arabia and UAE(specifically Abu Dhabi) was the implementation of the compulsory national healthinsurance policy. Qatar is also legislating to make it mandatory to hold anational health insurance policy, which will drive demand of its takaful industry. Malaysia, with a relatively developedIslamic finance industry, has actively supported the growth of its takaful sector. In fact, Malaysia has emerged as theworld’s largest family takaful market. With a proven model and regulatoryclarity, the country is set to further build on this leadership position.Family and medical takaful are the major business lines across all markets.
Scale in the protection space is very important andthis has been a challenge outside of Saudi Arabia and Malaysia. Regulatoryenhancements are also presenting new opportunities in rapid growth markets suchas Turkey and Indonesia. The challenge is to build on the lessons learned fromcore Islamic finance markets to address rising demand expeditiously.CONCLUSIONTakaful is in many ways the ‘sleeping giant’ of theIslamic finance industry.
As highlighted at the beginning of this chapter,protection against the risks we face as human beings is a basic need. With thesignificant and growing Muslim demographic across the world, a tremendousopportunity exists to provide sharia-compliantprotection solutions. Conventional insurance still dominates across the Muslimworld (in a report by Swiss Re in 2011, 83.1 per cent of premiums went toconventional insurance providers in Muslim countries2)and in most of the non-Muslim world there is very little provision of takaful.For the takaful industryto compete with conventional proprietary insurance, it needs to achieve scale,a more accessible regulatory framework, have suitable long-term investments forthe family/life takaful market and attain operational efficiency. Scaleis important to overcome significant start-up costs, provide competitivepricing and mitigate the risk of insolvency.
Regulation in individualjurisdictions and the regulatory framework across borders need to be simplifiedto allow larger, regional players to develop. A lack of relatively stable,long-term sharia-compliant investments has been an issue – these areneeded to match the long-term nature of family/life takaful plans and the fact that these plans have astrong investment focus. Instruments such as longer-term sukuk arerequired to support the growth of the takaful industry.World-class standards of operational efficiency are required to competeeffectively with the well-established conventional insurance market.
