Conventional and Takaful Differences - Essay Example

Conventional and Takaful differences Name Institution Course Date Conventional and Takaful Differences Introduction Insurance is considered one of the most important financial services in a country’s economy. Insurance offers an opportunity to people to transfer uncertainty to the insurer for predetermined amount (Ahmed, 2010). The insurer is able to offer financial compensation in case of a loss. Insurance is considered a transfer mechanism where uncertainty is exchanged for certainty of financial compensation. The act of taking prophylactic measures also referred to as “ikhtiar” is in line with Islamic teachings. In Islamic teachings, people are encouraged to be prepared for uncertainty and be ready to take some measures to protect themselves through insurance policies (Antonio, Ali and Akbar, 2013). Therefore, insurance is a concept that does not at any way contradict with the teachings of Islam. From this, Islam insurance or Takaful was formed. There are a number of differences between conventional and Takaful insurances (Antonio, Ali and Akbar, 2013). This assessment will present the differences between Islam and conventional insurance in terms of principles, terminologies, and mechanisms. Principles One big difference between Takaful and conventional insurance is the concept of law. Takaful insurance companies are founded upon sharia laws (Yusop et al., 2011). The first “fatwa” that banned the modern application of insurance and its activities among Takaful insurance companies was created by Abdeen, a Syrian scholar. Although opinions differ among Muslim intellectuals, majority argue that modern principles of conventional insurance companies are unacceptable to Islam (Yusop et al., 2011). While Takaful insurance is based on the principle of sharia, conventional insurance was founded upon manmade laws. There are a number of elements and principles that differ between Takaful and conventional insurance. One principle of conventional insurance is “al-maisir” also known as gambling. The insurance policyholder often losses the financial compensation when the loss does not take place (Yusop et al., 2011). In addition, the policyholder may receive a large amount of financial compensation more than what is deserved (Hussain and Pasha, 2011). This means that the insurance company often pay indemnity to the policyholder when a loss occurs and the insurance holder pay premium if the loss does not occur. Such a principle does not apply in Takaful insurance (Hussain and Pasha, 2011). In such insurance companies, the policyholders are expected to donate some amount of capital to assist other people who may suffer from loss. Takaful insurance is based on the principle of mutuality as the risks are not transferred but shared among policyholders (Hussain and Pasha, 2011). All participants form a common pool where money is kept and transferred to anyone who may need help in taking care of a loss. In addition, conventional insurance is based on “gharar” which means uncertainty. However, in Takaful insurance, uncertainty is against sharia rules (Hussain and Pasha, 2011). Sharia law prohibit the sale of any contract that encompasses probability or uncertainty. In conventional insurance, the insurer and the insured do not know when the loss will take place or the about required to cover the loss (Iqbal, 2001). This type of situation is uncertain and unknown. However, Takaful insurance has a structured pool of funds which enable policyholders to assist each other in taking care of a loss. The policyholders are arranged in such a way that there are no uncertainties or probability as they tend to donate their financial contributions to a pool of fund and in return receive a larger amount based on the principle of sharing of losses and profits (Abidin, Zaini and Ali, 2012). This makes sure there is no risk transfer but risk sharing. Moreover, conventional insurance is based on the principle of “riba” also called interest. Interest means making money on money (Abidin, Zaini and Ali, 2012). According to sharia rules, there should not be any form of interest in any business activity. Almost all conventional insurance companies base their business in interest-bearing assets. All Islam insurance is considered interest-free system. This means that Takaful insurance companies must make sure that the policyholders’ money as well as all the shareholders’ funds are invested in assets that do not attract any interest and any bank that they associate with does not take part in the practice of riba (Abidin, Zaini and Ali, 2012). Terminologies The term Takaful comes from Arabic name “kafala” which means a guarantee or a protection. With regard to the Islamic interpretation, Takaful is a form of a pact among policyholders who agree to assist each other in taking care of the occurrence of losses (Farooq et al., 2010). It is a joint guarantee where a group of people contribute some agreed amount of money into apoo and assist those who suffer from loss. In the Islamic interpretation, the practice of Takaful insurance should be in harmony with the concept of al-Mudharabah which is acceptable in the eyes of Alla. Takaful insurance companies and conventional insurance also differ in terms of terminologies (Farooq et al., 2010). Takaful insurances adhere to the concept of Ta’awun which means cooperation as well as Tabarru’ which means donation. The operation of Takaful insurance companies is based on these two concepts while the conventional insurance does not necessarily follow the concepts of cooperation and donation (Farooq et al., 2010). Conventional insurance are based on terminologies formed under manmade laws. For instance, indemnity is a famous term in conventional insurance which means the compensation for damages or losses that may occur (Abidin, Zaini and Ali, 2012). The concept of indemnity entails a contractual agreement between an insurance company and a policy holder (Abidin, Zaini and Ali, 2012). In Islamic insurance, the concept of indemnity does not exist since policyholders donate money to help those faced with losses. In addition, the concept of subrogation applies to conventional insurance but not to Islamic insurance companies. Subrogation involves a situation where an insurance company on behalf of the policyholder has legal right to sue a third party who has caused losses to the policyholder (Abidin, Zaini and Ali, 2012). Islamic insurance involves a great deal of cooperation and donation and therefore does not involve taking legal action on an individual who causes a loss. In the Takaful insurance companies, the contribution paid by the policyholder is referred to as tabarru which is contributed in the spirit of Ne’ea (purity) (Antonio, Ali and Akbar, 2013). This form of contribution eliminates the concept of gambling. In conventional insurance companies, the contribution paid is referred to as premium paid against claim. This encourages the concept of gambling since if a loss does not occur, the amount paid as premium by the insured is lost (Antonio, Ali and Akbar, 2013). Takaful insurance companies tend to have Re-Takaful companies or re-insurance companies that are under the sharia law. However, conventional insurance does not automatically have re-insurance companies that adhere to sharia principles (Antonio, Ali and Akbar, 2013). Mechanisms In conventional insurance, surplus or profit that is gotten from the operations of the company goes to the shareholders. The policyholder or the insured is covered during the coverage period; nevertheless he or she is not entitled to receive any return during the completion of policy period (Antonio, Ali and Akbar, 2013). On the other hand, Takaful insurance companies operate following a mechanism that encourages the surplus or profits to go to the participants. Profits and surplus are eventually returned to the participants in the proportion of their share contribution (Gait and Worthington, 2008). Conventional insurance companies often invest in instruments such as bonds, and securities in order to earn interest. However, due to the Islamic prohibition of the concept of riba or interest, Takaful insurance companies do not invest in bonds or security but only use riba-free instruments (Gait and Worthington, 2008). Conventional insurance is based on a risk transfer mechanism where the risk of loss is transferred from the insured to the insurer (Hussain and Pasha, 2011). This differs from Takaful insurance where the mechanism of risk sharing is used. The insurance company only acts as the manager of the pool of resources. In addition, there is a contract difference between Takaful insurance and conventional insurance companies (Gait and Worthington, 2008). Takaful operation is founded upon a mutual assistance agreement, profit sharing, and donation contract between policyholders and the company which is different from conventional insurance companies which have a contract that is founded on the basis of sales and purchase between policyholder and insurer (Gait and Worthington, 2008). Another huge difference between Takaful and conventional insurance companies comes in form of moral obligation to the society. Takaful insurance companies are expected to contribute to societal schemes in order to fulfil the commands from Qur’an that encourage help to people who need it (Farooq et al., 2010). However, conventional insurance company focus more on fulfilling the needs of the stakeholders. These companies are focussed more on making profits without moral restrictions. Conventional insurance companies are classified as Life and General Businesses while Takaful insurance companies are classified as Family and General. Takaful is centered on four business models including Mudharaba Model which means profit sharing, Wakala model which means fee-based agency, Wakala-Mudharaba and Waqf Model (Farooq et al., 2010). The operation of Takaful insurance companies is governed by both the legislation laws and sharia laws while conventional insurance companies are governed by legislation laws only (Farooq et al., 2010). Also, the mechanism of voting for directors differs between the two. In conventional insurance company, policyholders cannot take part in election of directors or access the annual financial accounts. However, Takaful insurance allow the policyholders to vote for directors and see the annual accounts (Farooq et al., 2010). Financial Statements UAE is among the countries that have adapted dual insurance system since both the Takaful and conventional insurance companies operate side by side (Soekarno and Azhari, 2009). The increase in awareness of Takaful finance has led to the enhancement of competition in insurance industry in UAE. There are a number of research studies that argue that Islamic insurance companies perform better than conventional insurance company (Soekarno and Azhari, 2009). However, in UAE conventional insurance companies have for many years performed better than Takaful insurance companies. Most conventional insurance companies in the UAE perform financially better than Takaful insurance companies (Janahi and Weir, 2005). For instance, compared to Emirates insurance company, Takaful Emarat Insurance Company has for a long had less assets and total profits. The financial strength of Takaful insurance’s assets is low compared to conventional insurance due to its limitation to invest in interest-based instruments (Soekarno and Azhari, 2009). Most conventional insurance companies have huge amount of total assets since they are able to invest in numerous instruments without any restrictions. Takaful insurance investments are mostly governed by the provision of sharia laws (Soekarno and Azhari, 2009). Conventional insurance companies in UAE have higher capital based compared to Takaful insurance companies (Janahi and Weir, 2005). This gives conventional insurers an upper hand to tackle potential capital contingency. In addition, due to low profitability and capital contribution in most Takaful insurance companies compared to conventional insurer, the companies are mostly small in size since their financial position determine their growth and development (Janahi and Weir, 2005). In addition, the unattractive financial performance of Takaful is attributed to its focus on countering poverty and helping the people in need. In UAE, Takaful insurers are seen as companies that are meant to deal with poverty and enhance sustainable economic development (Janahi and Weir, 2005). Profit generation is not stressed too much as in conventional insurance companies. Conclusion Takaful insurance companies have grown significantly over the years which have intensified competition in the insurance industry. There are different elements that differentiate conventional insurance companied from Takaful insurance companies. For instance, conventional insurers are based on the mechanism of risk transfer while Takaful are based on the mechanism of risk sharing. In addition, conventional insurers have an element of uncertainty and are free to invest using interest-based instruments like bonds and securities. However, in Takaful insurance companies, uncertainty is against sharia laws and funds can only be invested in riba-free instruments. Due to the principles of Takaful insurance and the need to adhere to the sharia laws, the financial performance of the companies is poor compared to that of conventional insurance companies. References Abidin, S. Y., Zaini, M. M., and Ali, H. M 2012, “A study on Takaful and conventional insurance preferences: The case of Brunei”, International Journal of Business and Social Science, Vol. 3, No. 22, pp. 163-176. Ahmed, A 2010, Global Financial Crisis: An Islamic Finance Perspective. International Journal of Islamic and Middle Eastern Finance and Management, Vol. 3 No 4, pp. 306-320. Al Janahi, A and Weir, D 2005, Alternative Financial Rationalities in Managing Corporate Failure. Managerial Finance, 31(4), pp. 34-45. Antonio, M.S., Ali, M.M and Akbar, N 2013, A Comparative Analysis of the Efficiency of Takaful and Conventional Insurance in UAE. International Journal of Excellence in Islamic Banking and Finance, Vol.3, No.1, pp.1-13. Farooq, S. U., Chaudhry, T. S., Alam, F & Ahmad, G 2010, An analytical study of the potential of Takaful companies. European journal of economics finance and administrative sciences, Vol. 20, pp. 55-75. Gait, A and Worthington, A. C 2008, An empirical survey of individual consumer, business firm and financial institution attitudes towards Islamic methods of finance. International Journal of Social Economics, 35(11), 783-808. Hussain, M.M & Pasha, A.T 2011, Conceptual and operational differences between general Takaful and conventional insurance. Australian Journal of Business and Management Research, Vol. 1, No. 8, pp. 23-28. Iqbal, M 2001, Islamic and conventional banking in the nineties: a comparative study. Journal of Islamic economic studies, Vol. 8 No. 2, pp. 1-7. Soekarno, S & Azhari, D.A 2009, Analysis of financial ratios to distinguish joint venture general insurance company performance using discriminant analysis. The Asian journal of technology management, Vol. 2 No. 2, pp. 110-122. Yusop, Z., Radam, A., Ismail, N & Yakob, R 2011, Risk management efficiency of life insurers and takaful operators. Insurance markets and companies: analysis and actuarial computation, Vol. 2 No.1, pp. 58-60. Appendices Table 1 Financial statement of Emirates Insurance Company indicating profit Table 2 Assets and Liabilities of Emirates Insurance Company Table 3 Financial Statement of Takaful Emarat Insurance Company Read More