Takaful is NOT an Islamic contract or structure in itself, but rather the result of the combination of two or more Islamic contracts, and in general is the combination of a tabaru’ (donation) operation with one or more Islamic contracts like Wakalah or Mudarabah.
For years the insurance concept was prohibited by Islamic scholars, until 1985, when the Grand Council of Islamic Scholars in Makkah, based on the concept of a cooperative tabaru’ and cooperation, approved the Takaful system as an alternative to conventional insurance. However, the exact method and operation of Takaful was left to Islamic scholars and insurers to resolve develop and implement.
The word “takaful” originates from the Arabic word kafalah, bearing the reciprocal dimension of “guaranteeing each other” or “joint guarantee”.
The concept of “Islamic compliant insurance” dates back to some 1,400 years ago when the Muhajirun of Mecca and the Ansar of Medina would agree to contribute to a fund before starting long voyages, where often they incurred huge losses, misfortunes or robberies along the way. This “common fund” would be kept with one of the group members, and would be used to compensate any member who suffered mishaps during the journey.
General Takaful, or sharia-compliant, life insurance has been traced to another Muslim practice of pooling contributions from a group of people to assist others in need.
Simply put, today Takaful is the sharia-compliant alternative to conventional insurance. But what’s wrong with conventional insurance and why does it warrant a sharia alternative?
Is it the prohibition of riba (interest)? Not really, because riba is not inherent to the insurance business — and one may structure conventional insurance models without interest bearing investments.
Is it the prohibition of gambling (maysar)? But here again, gambling is not inherent to the insurance business. Gambling occurs only if the insurance results in a financial gain to the insured in excess of compensation of damages.
Is it the prohibition of risk? This another misconception. In fact, risk is not prohibited by sharia. On the contrary, risk is intrinsic and inherent to the very concept of halal business and profit. According to sharia principles, reward must be accompanied by risk. But sharia distinguishes between market risk and credit risk. While credit risk alone is not permissible, market risk is a requirement for any halal benefit. This is why for example investment in stock is permissible (market risk) while investment in bonds is not (credit risk).
So what is the major reason for the prohibition of insurance under sharia? This lies in the “gharar” (uncertainty) component of the insurance contract. “Uncertainty” is different from “risk.” Contracts that provide for “uncertain” obligations are not permitted. In conventional insurance, the service offered by the insurer (indemnification of a loss) may or may not be forthcoming depending on whether the loss occurs or doesn’t occur. Therefore, the obligation of the insurer lacks the component of “certainty” and is hence prohibited. In other terms, whilst market risk is legitimate, the “transfer” of such risk in return for a fee without transfer of the corresponding reward, is not permitted under sharia principles.
So how does sharia overcome these prohibitions? We said that premium payment in return for “uncertain” services is not allowed, but payment of a participation as a gratuitous “donation” for social well being is permitted under sharia.
Under Takaful, premium is not a price for the coverage. Premium is a contribution in a mutual scheme or mutual fund which aim is to mutually guarantee each other against an uncertain event. Whilst in conventional insurance, the insured is a customer of the insurance company, in takaful the insured is both the customer and the principal. Part of the premium goes as an irrecoverable donation to cover any potential losses of any of the participants, and the other part of the premium is invested in sharia compliant investments.
There are two major types of Takaful namely the Wakalah model and the Mudaraba model. In addition, the concept of “waqf” is sometimes used to structure takaful operations.
The Wakalah model is mostly used in the Middle East while Malaysian companies commonly use the Mudaraba model.
Regardless of the chosen model, Takaful is similar to a mutual insurance where the purpose is to share risk between members, thus making it more manageable for each of them. A common fund is created (the Takaful Fund). This represents a percentage of each of the participant’s policy holders payment. The Takaful Fund is owned by the participants (the contributors) and is managed by an operating company the “Takaful Operator” (TO).
One of the most significant challenges of the Takaful industry is the re-Takaful or sharia-compliant reinsurance. This industry is at the early stages of its development and most Takaful companies undertake re-insurance with conventional reinsurers. Finally, it is worth mentioning that some sharia scholars defend the position whereby the insurance business does not violate sharia when the premium is calculated on the basis of scientific statistical computations, given that such scientific calculations remove the component of “gharar,” provided of course that other sharia aspects are complied with. However, this remains an endless argumentation that is arguably unproductive. The Takaful market is real and has incredible growth potential. It is certainly more productive to focus on how to develop and move the Takaful industry forward rather than concentrating on endless theoretical and theological debates.
Nada Abdelsater-Abusamra is an attorney at law in the courts of New York and Beirut. Corporate and advisor to regulators and banks in Islamic finance.
