Takaful - the Islamic insurance

Reduce risk, but halal!

16.11.2017|Islamic Finance
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One way to reduce the risk of loss due to unforeseen events in the modern economy is through insurance. The concept of insurance, which pools funds to support those in need, aligns fundamentally with Islamic principles.

In the following blog, we will highlight key aspects that distinguish Islamic insurance from conventional insurance.

Not only financial instruments, such as investments or financing, need to be Sharia-compliant, but also insurance. The version of a Sharia-compliant insurance is called Takaful.

Characteristics of Sharia-compliant insurance:

Takaful can be understood as a solidarity community of members or as a kind of cooperative principle. Members share in both profits and losses. The core of the Takaful principle is the honest intent and sincerity of the parties involved.

Conventional insurance structures are not Sharia-compliant for various reasons, which we will outline later, and thus require adaptation to ensure compliance.

The specific use of paid premiums and surplus usage must comply with Islamic Finance rules.

The following key elements align Takaful with Islamic Finance:

    • Joint risk-sharing to protect members
    • Incorporation of a donation or endowment concept to eliminate speculative transactions on uncertain events (Gharar) in insurance contracts
    • Avoidance of interest-based transactions (Riba) and the use of insurance contracts as a form of gambling or unfair profit-making (Maysir)
    • Clear separation of roles between members and the insurance company
    • Differentiation of funds between shareholders and policyholders
    • Distribution of technical surpluses to the members of the insured community
    • Compliance with all transactions and investment premises of insurance funds according to Islamic Finance norms

The structuring of Takaful can be based on various Islamic financial models. Two of these models are particularly significant in practice and are presented below:

I. Sharia-compliant insurance according to Mudaraba

The Mudaraba model emphasizes a strict separation between the insurance company and the policyholders. In Takaful, the policyholders are the capital providers, and the insurance company acts as the operator and manager, responsible for collecting contributions, managing the company, structuring and executing insurance contracts, and paying out claims. A profit-sharing ratio is agreed upon in advance between the parties.

II. Sharia-compliant insurance according to Wakala

The Wakala model functions similarly to an agency contract. The insurance company receives a fixed fee for its services, known as the Wakala fee, deducted from the paid premiums. Any other earnings or surpluses are distributed to the policyholders.

The difference from conventional insurance

Conventional insurance contains several components prohibited in Islamic jurisprudence. Therefore, in their available form, they are not Sharia-compliant and are not an alternative. The commission of Islamic scholars divides this issue into three main elements:

Uncertainty | Speculation (Gharar)

A conventional insurance contract is essentially an exchange transaction, i.e., a purchase and sale transaction. The policy (indemnity) represents the good sold to the policyholder, and the policyholder's premium is the price or consideration for this good. From an Islamic Finance perspective, conventional insurance contains elements of Gharar (uncertainty and speculation). Gharar arises because, at the start of the contract, it is uncertain whether a loss will occur, and if so, when and to what extent. While no new risk is created, an existing risk is reduced or eliminated. If no loss occurs, the insurance company gains the policyholder's paid amount. This introduces an element of uncertainty concerning the insurance contract's subject matter, which is not allowed in Islamic Finance.

Gambling (Maysir)

The second component of conventional insurance that contradicts Islamic Finance principles is the gambling aspect. Insurers hope that certain circumstances (loss events) do not occur, resulting in further profits for the insurers. If the insured loss does not occur, the policyholder loses the premium payment. Conversely, the insurance company incurs deficits/losses if the loss exceeds the policyholder's paid premiums, leading to higher premiums in future periods.

Interest (Riba)

The prohibition of interest is central in Islamic Finance. All contracts and transactions must be free from interest elements.

However, a conventional insurance company invests a large portion of the collected premiums in interest-bearing securities or accounts.

Consequently, conventional offerings are not a suitable solution for principled individuals.

Islamic Finance only opposes the operation of conventional insurance but not the idea of protection, precaution, and mutual support in times of difficulty and misfortune. It does not oppose preventive measures to mitigate potential dangers and risks. Islamic sources even encourage prevention to ensure risk protection.

When asked by a Bedouin whether he should tie his camel or trust in God, the Prophet Muhammad replied with the well-known statement: “Tie it and trust in Allah.” (Sunan At Tirmidhi #2517, hasan).