Takaful is about risk-pooling while proprietary insurance is concerned with risk transfer

Camille Paldi

January 13, 2015: Takaful, or Islamic insurance, is a cooperative scheme, where in the participants pay a premium in the form of donation, or tabarru, in a common pool in return for the ability to draw upon that pool upon a valid claim. The word takaful originates from the Arabic world kafalah, which means “guaranteeing each other” or “joint-guarantee.” The basis of shared responsibility is taken from the system of aaqilah, which was an arrangement of mutual help or indemnification customary in many tribes of the Arab world. Under this system, if a member of a tribe was accidentally or unjustly killed, the murderer was obliged to pay blood money (dia) to the deceased’s next of kin as a form of life insurance for the deceased’s relatives.

Proprietary insurance is concerned with risk transfer, insured risks being transferred from the insured to the insurer in return for a premium. Takaful is concerned with risk-pooling, whereby the policyholders mutually insure one another in a common risk pool financed by their contributions (premium payments). The purpose of this system is not profits, but to uphold the Qu’ranic, Christian, and Jewish principle of “bear ye one another’s burden“. Therefore, in contrast to conventional insurance, takaful is not a contract of buying and selling where a party offers and sells protection and the other party accepts and buys the service at a certain cost.

Rather, it is an arrangement whereby a group of individuals each pay a fixed amount of money while compensation for losses incurred by members of the group is paid out of the total sum. The funds remaining in the takaful fund on maturity of the policy are distributed among the participants after deduction of the charges due to the operator and according to the type of takaful management model utilised by the fund.

In conventional insurance, one enters a bilateral sale contract or contract of exchange with the insurance provider and transfers risk of loss to the provider. The provider will bear the risk of loss in the event of an accident or harm to the insured item or person. In addition, the insurance provider speculates on risk in the underwriting process. A conventional insurance company speculates on the risk by making an assessment of the risk and then pre-determining profit based on the estimated payout versus the premium. It is in a sense gambling. In regards to transfer of loss or speculation on risk, there is neither in takaful.

In Islamic insurance, the loss and risk are essentially distributed amongst the policyholders. Overall, takaful is a scheme of mutual protection that exists amongst the participants making them both the insurer and the insured, which is a concept promoted by all of the people of the Holy Books.

In conventional insurance, riba (interest) occurs as the amount of money received by the insured, either on the occurrence of the insured event or upon maturity of the policy may be more or less than what is actually paid by the insured.  Furthermore, since the payments are deferred, the compensation paid, which is greater than the instalments paid by the insured may constitute surplus riba (riba al fadl) and credit riba (riba al-nasiah). Secondly, the profits of conventional insurance companies result from riba related transactions (ISRA: 2012).

In addition, conventional insurance contracts contain gharar (uncertainty) in that the subject matter of the contract is not certain until the insured event has taken place. The amount being paid by the two parties is not known at the time of execution of the contract. For example, an accident may occur immediately after the insured makes the first payment requiring a payout or he or she may make all the payments without any accidents happening, never receiving any compensation back from the insurance company during the duration of the policy (ISRA: 2012).

In a conventional insurance contract, the policyholder agrees to pay a certain premium sum in consideration for the guarantee of the insurance company that they will pay a certain sum of compensation in the event of a valid claim. However, the policyholder is not informed of how much compensation the company will pay him or her or how the amount shall be derived (ISRA: 2012).

Maisir, or gambling, means to court such risk as it involves both the hope of gain as well as the fear of loss, which is not a necessary part of any normal activity in life.  In conventional insurance, policyholders are gambling by betting premiums on the condition that the insurer will make payment contingent upon the circumstance of a specified event. On the other hand, the insured does not get anything from his premiums if the insured event does not happen at all (ISRA: 2012). Takaful minimizes riba (interest), gharar (uncertainty) and maisir (gambling)through its cooperative donation scheme (tabarru) and investment in halal activities.

The general takaful contract is a short-term policy where participants pay contributions and operators undertake to manage the risk. According to ISRA (2012:512), contributions by the participants are credited into the general takaful fund, which is then invested and the profits generated are paid back to the fund and eventually to the participants in accordance with the terms of the contract in a pre-agreed upon ratio after deducting operational costs.

The tabarru element is more apparent in general takaful as participants will normally undertake to regard their contributions as donations to fellow participants (ISRA, 2012:513). Tabarru is an agreement by a participant to relinquish, as a donation, a sum of contribution that he or she agrees to pay with the purpose of providing mutual indemnity to takaful participants, where the donation acts as a mutual help and joint guarantee should any fellow participants suffer from a defined loss (ISRA, 2012: 514). Tabarra is derived from the word tabarra’a, which means contribution, gift, donation, or charity. The purpose of this contract is to give a favour to the recipient without any specific consideration in return. Essentially, it is a contribution or donation, which entails no return, but rather a reward from Allah alone. There are two important pillars of tabarru, namely the absence of counter-value and the intention to perform tabarru. For example, if a donor contributes with an expectation of a counter-value from the donation given, then the whole transaction will be perceived as an exchange (muawadah) rather than a tabarru contract.

Takaful, unlike its conventional counterpart, is based on the principles of mutual cooperation (ta’awun) and donation (tabarru). Under the Islamic law of transactions, the existence of gharar (uncertainty) and maisir (gambling), which normally nullifies an exchange contract (muawadah), are tolerated in a contract of donation (tabarru). This corresponds to the Islamic legal maxim, “uncertainties are tolerable in a gratuitous contract“. This is mainly due to the fact that parties who enter into a tabarru contract do not aim to make profit out of the contributed sum, and hence the potential dispute, which normally arises in a profit-making transaction is deemed to be negligible in a gratuitous-based transaction. Furthermore, the issue of uncertainty is nullified as the contributor voluntarily gives away his property or right to the recipient without any consideration.

In contrast, conventional insurance is based on exchange (muawadah), aims at making profit from the insurance operations, and is not shari’ah compliant due to excessive gharar (uncertainty), maysir (gambling), and riba (interest). A takaful contract cannot be considered a pure tabarru contract, but rather a qualified or conditional tabarru contract due to the following reasons: (1) The contribution made by a participant is with consideration to a right to claim for compensation in the event of loss or damage of subject matter. Thus, the tabarru is not merely for charity, but conditional upon certain consideration, namely the right to claim takaful benefits in the event of loss. This is a violation of the fundamental objective of tabarru.  (2) Takaful participants are normally obliged to pay different amounts of contributions depending on the different degree of risk exposure. This implies that their participation in the fund is conditional upon a certain amount of contribution, which deserves compensation. This is in contradiction to the principle of tabarru as the real intention of the contracting parties is not for donation, but rather to make them eligible for certain benefits under takaful. (3) Takaful includes a few controversial practices such as surrendering of benefit, survival of benefit, or sharing of underwriting surplus among participants of takaful although they have surrendered all of their rights over the monies of the fund. (4) Furthermore, when a participant pays a premium to the takaful operator, he has effectively donated his contribution as tabarru, hence, relinquishing his ownership over the object donated as prescribed by the rules of tabarru. Therefore, it should not return to the participants upon maturity of the policy or liquidation of the fund. Many takaful products and operations are starting to converge closely with conventional insurance.

The fundamental structure of takaful, which is premised on the basic concept of tabarru, is questionable as many benefits are offered to the participants in the beginning of the takaful contract in return for the contributions paid to the tabarru pool managed by the takaful operators.

Takaful participants are not insured in the sense of proprietary insurance, but share the profits and bear the deficits of the takaful undertaking in a manner similar to conventional mutual insurance. The takaful operator plays an important role that the management of a conventional mutual does not play in the event of a periodic deficit in a takaful fund that exceeds the reserves of the fund, thereby making it potentially insolvent. In this case, the takaful operator acts as a lender of last resort by providing a qard hassan loan to the takaful fund. Such a loan will be repaid out of future underwriting surpluses. In mutual insurance and takaful, investment profits belong to the policyholders, except that, in takaful, the operator may share in these profits as a mudarib or by virtue of a performance-related wakalah fee for fund management.

The concept of risk-pooling is promoted in all of the Holy Books, including the Torah, the Bible, and the Qu’ran. Therefore, takaful should be seen as a form of Holy Book insurance and promoted amongst all of the people of the Book and among those who favour conventional mutual insurance or cooperative societies. One of the core concepts of takaful is that the participant retains ownership over the paid premiums to the takaful fund and, therefore, has the right to reclaim the unused premiums at the end of the policy. This form of risk-sharing and investment insurance has a positive effect on the health of the individual through maximising coverage and on the economy as a whole as more funds are available to promote productive trade, which may stimulate economic growth.

Camille Paldi is CEO of Franco-American Alliance for Islamic Finance

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