Islamic Insurance or Takaful

NEW HORIZON July-December 2014

Overview of Takaful

Islamic insurance, and, more broadly, Islamic finance, place special emphasis on social welfare as a criterion of business practice. In addition to the importance placed on welfare, there is also a strong focus on discouraging wealth maximisation. Islamic insurance tends to incorporate both of these ideals in its approach to affording security to individuals in the form of insurance. Thus, Islamic insurance is a cooperative model of insurance.

There are no counterparts to conventional insurance in classical Islamic law. Islamic insurance is an innovative modern approach to dealing with demand for an instrument that can reduce one’s exposure to certain types of risk. Under its conventional form, insurance is similar to a gamble and would be a violation of the rules of gharar. In a conventional agreement, an insured person pays a cash premium in exchange for a promise made by the insurer that it will pay a certain amount in case of a given future contingency. There is no guarantee that the future contingency will ever come to pass and disputes about whether the contingency has occurred or pre-existed the contract have bred enormous litigation. Thus, the insured is taking a gamble and the insurer is benefiting from this gamble. Under conventional insurance practice, the operation of insurance is also heavily reliant on principles of interest. Insurance companies often invest their premiums in interest-bearing investments, which also invokes the prohibition against riba.

An influential Islamic scholar, Mustafa al-Zarqa, made an argument for the acceptability of conventional insurance practices as insurance contracts in the aggregate pose very little uncertainty, since the risk for which the parties are contracting can be valued.

This argument was not enough to quell the general unease pious Muslims have with the idea of conventional insurance. Thus, a new approach emerged which shifted the conceptual focus of insurance away from individual contractual agreements and towards the institution of insurance’s benefit to society as a whole.

Islamic insurance shifts the focus to a broader lens—insurance as a collective endeavour, which is an alternative to the bilateral relationship that exists in the conventional model. It is this institutional approach that forms the basis for takaful. This collective model grew out of the social insurance practices that were practiced at the beginning of Islam, such as al-diyah (blood money), a practice in which the relatives of a killer paid money to the heirs of the deceased in order to allow the killer to escape his legal burden. These amounts were to be paid by way of mutual collaborations in which money was set-aside in case the need arose for its use.

Takaful, which literally means solidarity, is a system in which members decide to protect each other from loss. In line with Islamic ideals of welfare and charitable giving, the system is a collective enterprise that allows a community to pool together resources in order to assist members of the community in times of need resulting from casualty or loss. Professor Tom Baker characterised the differences in the theoretical underpinnings between conventional and Islamic insurance: conventional insurance seeks to eliminate risk for the individual, whereas Islamic insurance aims for risk elimination within a given social group.

While the scope of insurance policies within the takaful model may vary, they are governed by the principles of either a wakalah or mudharabah contract or a mixed model borrowing from both. The basic structure of a takaful arrangement is as follows:

1. a takaful company is organised;
2. members make periodic payments that the company maintains in individual accounts for each member;
3. these amounts are invested in Islamically sound financial products. As part of the contract, the members agree that if any of them suffer a covered loss, then each will make a proportionate gift from their accounts to cover that loss.

The legality of this contract is derived from the idea that gratuitous acts allow for a higher degree of uncertainty and from the Maliki (one of the four schools of thought in Sunni Islam) opinion that gift promises can be binding. Under this framework, the insurance pool is more akin to a charitable institution as opposed to a profit-earning institution, because the insurance company does not act like an insurer in the conventional sense; instead, it manages the business aspect of the cooperative on behalf of the members.

Finally, under a takaful model, there is generally a governing body, known as a Shari’ah board that regulates the takaful company to ensure that the products being offered by the company are within the confines of Islamic law (Shari’ah). The salient characteristic of takaful companies is that profits are shared by the policy holders rather than given to third-party shareholders as is the norm in conventional insurance companies.