TAKAFUL (ISLAMIC INSURANCE)

By: Camille Paldi

CEO of FAAIF

Mediterranean Week of Economic Leaders Summit of Islamic Finance, 28th of November 2014. Casa Llotjade Mar, Barcelona, Spain

Forum organized by:

WHAT IS TAKAFUL?

Takaful, or Islamic insurance, is a cooperative scheme, where in which 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."

AAQILAH

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.

CONVENTIONAL V ISLAMIC INSURANCEProprietary 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 (takaful participants) mutually insure one another in a common risk pool financed by their contributions (premium payments).

CONVENTIONAL V ISLAMIC INSURANCE The purpose of this Holy Book insurance 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 or price.

Rather, it is an arrangement whereby a group of individuals each pay a fixed amount of money and compensation for losses of members of the group is paid out of the total sum.

CONVENTIONAL V ISLAMIC INSURANCE Return On Funds for the Participant.

The funds remaining in the takaful fund on maturity of the policy are distributed back to the participants after deduction of the charges due to the operator and according to the type of takaful management model utilized by the fund.

CONVENTIONAL V ISLAMIC INSURANCE 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.

CONVENTIONAL V ISLAMIC INSURANCE 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 (Paldi: 2014).

In regards to transfer of loss or speculation on risk, there is neither in Takaful.

CONVENTIONAL V ISLAMIC INSURANCE 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 (Paldi: 2014).

CONVENTIONAL V ISLAMIC INSURANCEIn 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).

CONVENTIONAL V ISLAMIC INSURANCE 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.

CONVENTIONAL V ISLAMIC INSURANCE 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).

CONVENTIONAL V ISLAMIC INSURANCE 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).

CONVENTIONAL V ISLAMIC INSURANCE 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 AND GHARARTakaful minimizes riba (interest), gharar (uncertainty), and maisir(gambling) through its cooperative donation scheme (tabarru) and investment in halal activities.

GENERAL TAKAFUL

The general takaful contract is a short-term policy where takafulparticipants pay contributions and operators undertake to manage the risk.

According to ISRA (2012:512), the contributions paid 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.

GENERAL TAKAFUL

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).

GENERAL TAKAFUL

Tabarra is derived from the word tabarra'a, which means contribution, gift, donation, or charity.

The purpose of this contract is to give a favor to the recipient without any specific consideration in return (Al Huda CIBE).

Essentially, tabarru is a contribution or donation, which entails no return, but rather a reward from Allah alone.

GENERAL TAKAFUL

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 (Al Huda CIBE).

GENERAL TAKAFUL

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).

GENERAL TAKAFUL

This corresponds to the Islamic legal maxim, "uncertainties are tolerable in a gratuitous contract." (Al Hude CIBE)

This is mainly due to the fact that parties who enter into a tabarrucontract 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.

GENERAL TAKAFUL

Furthermore, the issue of uncertainty is nullified as the contributor voluntarily gives away his property or right to the recipient without any consideration (Al Huda CIBE).

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).

GENERAL TAKAFUL

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 in takaful 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.

GENERAL TAKAFUL

(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.

GENERAL 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.

GENERAL TAKAFUL

(4) Furthermore, when a participant pays a premium to the takafuloperator, 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 (Al Huda CIBE).

GENERAL TAKAFUL

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 takafuloperators (Revisit the Principle of Tabarru in Takaful Structures).

CONVENTIONAL PROPRIETARY INSURANCE V CONVENTIONAL MUTUAL INSURANCE V TAKAFULTakaful 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.

CONVENTIONAL PROPRIETARY INSURANCE V CONVENTIONAL MUTUAL INSURANCE V TAKAFULThe 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.

CONVENTIONAL PROPRIETARY INSURANCE V CONVENTIONAL MUTUAL INSURANCE V TAKAFULIn 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.

Conventional ProprietaryInsurance

Conventional Mutual Insurance

Takaful

Contractual Relationship

A policy in the form of an exchange contract (sale and purchase) between the insured (policyholder) and the insurance company.

A policy in the form of a risk-sharing contract between the individual insured and the pool of insureds as represented by the cooperative insurance company.

A combination of tabarrucontract (donations) and contractual relationship between (a) the individual participants and the pool of participants, and (b) participants and the Takaful Operator, as represented by the takaful.

Responsibility of Policyholders/Participants

Policyholders pay premium to the insurer.

Policyholders pay contributions to the pool in the form of premiums paid to the cooperative insurance company. Any underwriting surplus belongs to the policyholders, who are also liable for any deficit. Annual surpluses are normally retained in underwriting reserves out of which any annual deficits are normally met.

Participants make donations (tabarru) to the scheme, as well as an element of savings in life takaful where a plan includes such a component. Any underwriting surplus belongs to the policyholders, who are also liable for any deficit (or see following alternative allowed by Shariáhscholars). In some takafulundertakings, the TO manages underwriting under a mudarabah contract and receives a share of the underwriting surplus as a mudarib fee. Something similar may also occur in a wakalah contract with a wakalah performance-related fee based on the surplus.

Conventional Proprietary Insurance

ConventionalInsurance Mutual

Takaful

Liability of the Insurer/Operator

Insurer is liable to pay claims according to the policy using the underwriting fund and, if necessary, shareholders funds.

Pool is liable to pay claims according to the policy using the underwriting fund.

Takaful operator acts as the administrator of the scheme and pays the takaful benefits from the takaful(underwriting) fund. In the event of the impending insolvency of a takafulunderwriting fund, the takafuloperator may be expected to provide an interest-free loan to the takaful fund to enable it to meet its obligations.

Access to Capital Access to share capital and debt with possible use of subordinated debt.

No access to share capital, but access to debt with possible use of subordinated debt.

Access to share capital by takaful operator, but not to debt, except for interest-free loan from operator to underwriting fund.

Investment of Fund There are no restrictions apart from those imposed for prudential reasons.

There are no restrictions apart from those imposed for prudential reasons.

Assets of the takaful funds are invested in Shariáhcompliant instruments.

I DEDICATE THIS PRESENTATION TO MICHAEL BROWN AND ALL THE VICTIMS OF EXCESSIVE POLICE VIOLENCE, BULLYING, HARASSMENT, AND SURVEILLANCE.

CONTACT FAAIF AT CAMILLE@FAAIF.COM

GRACIASSS