Islamic Insurance - Essay Example

?A. WHAT IS INSURANCE? According to Cathey Pareto, “Insurance is a form of risk management in which the insured transfers the cost of potential loss to another entity in exchange for monetary compensation known as the premium”. Since it is an explicit promise between the insurer and the insured to share the risk of the uncertain financial or personal loss, both parties sign a contract termed as insurance policy in which all the terms and conditions under which an insured is eligible for monetary compensation are mentioned. Insurance can be broadly classified into life insurance and general insurance which includes; health insurance, homeowner’s insurance, fire and theft insurance, auto insurance, disability insurance, appliance protection etc. However, on one hand insurance policies helps in risk management and shares the burden of unexpected losses with the insurance company. But on the other hand, this approach of risk management has been widely criticized by Islamic scholars because it violates the Islamic “shariah” law. This issue is the only factor for the unpopularity of the conventional insurance policies in the Islamic world. B. WHY IS CONVENTIONAL INSURANCE NOT PERMISSIBLE IN ISLAM? The conventional insurance contains within itself three elements of risk management which are prohibited in Islamic Shariah (Code of Conduct). 1. The first and the most criticized element is “Riba - interest”. Under no circumstances interest is allowed in any business or personal transactions. Therefore, neither any amount received in excess of the premium paid by insurer is allowed nor the Islamic insurance company is allowed to invest the collected funds in stock and bonds where interest is involved. But in traditional insurance the element of Riba is present. 2. The second issue is the involvement of “Gharar –uncertainty”. Since there is a huge ambiguity about the total amount that is to be received, the time of receiving the money and the eligibility of the insured to receive the money, therefore this type of insurance often leads to a win-lose situation in which one party gets the benefits at the expense of other party. 3. Conventional insurance is another name of “Maisir- gambling”. It is evident that both the parties have a hidden interest of gaining a huge sum with the policy. When the insured event doesn’t occur the insured person loses the sum invested in the policy and if the insurance claims are larger than the contributions then the insurance company is in deficit. The above three factors make conventional insurance “Haram- prohibited” in Islam. However, since safety and security is the basic human need in today’s uncertain world, therefore Muslim society needed an alternative to conventional insurance in order to secure their business transactions and personal interests. Islamic “shariah - code of conduct” is based on Muslim’s Holy book “Quran” and the sayings and traditions of the Prophet Mohammed, which preaches brotherhood and mutual interest in order to establish “just and equitable social order” in the society. Therefore, Takaful insurance was introduced to minimize the risk by mutual agreement which doesn’t exploit the interest of any party. C. TAKAFUL INSURANCE: “Takaful is an Arabic word, which means “joint guarantee” or “mutual co-operative agreement”. Tabarru is the basic pillar of Takaful insurance which means charity or gift”, (International Co-operative and Mutual Insurance Federation, 2005). Takaful insurance is based on the principles of Islamic brotherhood that promotes common interest and solidarity. Both parties share the responsibility with a sincere intention to help the other in his/her difficult time by paying the defined loss from the defined sum. D. CHARACTERISTICS OF TAKAFUL INSURANCE: 1. Both parties trust each other and contribute their money into a common pool. 2. The losses are divided so that the element of “gharar -uncertainty” is reduced and liabilities of each party under the losses are calculated according to the Islamic pooling system. 3. The policy should not contain terms and conditions aiming towards getting the benefits at the cost of risking other party’s interest. 4. Both parties subscribe to help the other through guaranteed compensation so that uncertainty is removed. 5. The insurance funds are invested in instruments that are interest free. These characteristics of takaful insurance doesn’t only have benefits on the micro level where individuals and their properties are protected but on the whole it plays a very important role in creating a balanced society where uncertainties are removed, looses are shared, business transactions are safer, exploitation of one party is prevented and people have a fair and equal chance to grow their businesses. E. DIFFERENCES BETWEEN CONVENTIONAL INSURANCE AND MUTUAL INSURANCE: 1. DEFINITION: “a Mutual insurance company is an insurance company which doesn’t have shareholders but instead is owned entirely by its policyholders. The profits are distributed to the policy holders in full” (wikipedia, 2011). While conventional insurance is a kind of risk management in which the insured transfers the risk in exchange of the premium paid to the insurance company. 2. INSURANCE CLAIMS: in mutual insurance, the company pays insurance claims from the underwriting funds while in conventional insurance, the company pays claims from shareholder’s equity and underwriting funds both. 3. REGULAR PAYMENTS: in mutual insurance, the participant pays contributions or donations while in conventional insurance the regular payments are called premiums. 4. CAPITAL: the capital of the company belongs to the participant and known as participatory capital under mutual insurance, while in conventional insurance, the capital recourses is the property of shareholders and is known as share capital. F. DIFFERENCES BETWEEN TAKAFUL AND CONVENTIONAL INSURANCE: 1. APPROACH TO RISK: in conventional insurance the risk is transferred from the insured to the insurer when the insured pays regular insurance premiums to the insurance company. On the other hand, in takaful insurance risk is shared between the insured and the insurance company while the takaful operator just plays the job of the agent who is the custodian of the funds. Also in conventional insurance “risk-taking” approach is adopted by both parties while in takaful insurance “risk management” approach is used. 2. RISK POOL: In conventional insurance the insurance company doesn’t create and maintain a separate risk pool. But in takaful insurance, a risk pool is managed which is the property of participants which allows the participants to make profits while the takaful operator only receives his fee and interest -free loans in case of deficits. 3. INVESTMENTS: in conventional insurance, the insurance funds are invested in interest bearing instruments which are most likely offering the highest return while in takaful insurance the funds are deposited where profits are expected and not the interest. 4. PROFITS: in conventional insurance the profit belongs to shareholders. The insured is only entitled to receive the amount needed to cover the loss during the policy period. Once that period is over, the contract is finished. On the other hand, in takaful insurance, the profits are shared and they belong to the participants. The profits are distributed in proportion to their capital investment at the end of the accounting period. 5. GAMBMLING: Since the profit and loss in conventional insurance is completely dependent on chance and uncertainty, therefore both parties try to protect their interest at the expense of the other. While in takaful, defined sum is paid from defined pool, which doesn’t make it a gamble. 6. UNCERTAINITY: In conventional insurance the amount of the insurance money to be paid is uncertain. Nobody knows when the incident will occur and how much compensation is to be paid to cover that loss. These uncertainties are only removed when the actual incident happens. However, in takaful insurance, the element of uncertainty is reduced with “tabbaru” system, where both parties sign a mutual guarantee to help each other in case of any accident. G. SIMILARITIES BEWTEEN TAKAFUL AND CONVENTIONAL INSURANCE: Although there is not much similarity between conventional and takaful insurance, but the purpose and the object of these types of insurances is the same. 1. Both types of insurances aim to make the business transactions safer and easier. 2. The collected funds are invested in financial instruments in order to gain profits. 3. Regular payments are received in both types of insurances under the name of “takaful-contributions” and “conventional-premiums” 4. It is a contract between two or more parties, which has legal considerations and can be challenged in country’s legal court; if it’s conventional insurance, and Islamic court; if it’s takaful insurance. H. CONVENTIONAL INSURANCE CONTRACTS: According to National Association of Insurance Commission (NAIC), insurance policy is a legal contract which may vary according to the legal requirements and the kind of insurance needed. However, all insurance contracts follow one general format which includes; declarations, insurance agreement, conditions, endorsements, definitions and exclusions. Given below are the most important essentials of conventional insurance contract which must be fulfilled: 1. OFFER AND ACCEPTANCE: offer and acceptance is the most essential feature of any legal contract. Here, the insurance company offers the proposed insurance policy to its potential client. When the client accepts the offer by signing the contract, the agreement takes place. The most important condition of a valid agreement is that it should be free of coercion. 2. COMPETENCE OF THE INSURED: the insured person must reach the age of majority (i.e. 18 years of age) and should have sound mental capacity in order to be competent to accept the insurance policy. In case, the insurance contract is about a minor i.e. a person below 18 years, his guardians can purchase the policy on his behalf. 3. CAPABILITY OF BOTH PARTIES: Both parties must be able to fulfill the promise and duties which they are required to do. The agreements should be realistic and insurance company should promise to pay the lump sum amount equal to its capabilities and resources. 4. LEGAL CONSIDERATION: the terms and conditions of the insurance policy should be designed in consideration of the legal requirements. Any contract which violates the legal considerations doesn’t have any legal entity. 5. CERTAINITY: All the terms and conditions should be explicitly mentioned and the contract should be clear and specific. It should not be vague and uncertain in order to create misunderstandings at the time of maturity. If the insurance company purposefully ignores some important aspects by not mentioning it in the policy, it is considered as fraud. 6. RECORDS: all the formalities of maintaining the written records and their registration must be fulfilled according to the requirements of contract law. Both parties must sign and stamp the documents and must register the documents in order to minimize the chances of fraud. 7. LAWFUL OBJECT: the object of the insurance must be legal and moral. The purpose of insurance should fall within the legal boundaries and all the legal requirements must be fulfilled. The insured must pay premiums on time and the insurance company must pay claims at the time of incident without causing unnecessary delays. Apart from this, the insurance contracts must be designed with utmost faith and should not conceal or misinterpret any information in order to deceive the other party. But if any of the party breaches the contract it is considered as void and can be challenged in the court. However, since the insurance contracts are conditional therefore, it includes a section of exclusions where the conditions are mentioned which makes the contract void. For instance, a person purchasing the life insurance policy can’t commit suicide and must go through physical examination in order to give proof of his fitness. I. TAKAFUL CONTRACTS: In order to provide an alternative to conventional contracts, takaful contracts are designed in conformance to Islamic shariah. Given below is the nature of takaful contracts which doesn’t only eliminate the elements of uncertainty, gambling and interest but also prohibits from investing in unlawful portfolios and buying and selling of unlawful property. 1. MODARBAH (PROFIT AND LOSS SHARING CONTRACT): the modarbah model is used in Malaysia, in which both parties invest in a profit and loss sharing account. Under this contract, participants bring the capital and required resources while the other party i.e. the takaful manager brings the required skills, knowledge and abilities. Both parties agree to share a certain percentage of profit if the insurance funds generate profits when they are invested in financial instruments. But on the other hand, if any calamity or unexpected loss is occurred and the amount of loss is bigger than the investment than both the parties suffer the loss. The participants suffer the monetary loss while the takaful manager doesn’t get the benefits or rewards for the efforts and skills provided over the period of time. 2. WAKALAH (CONTRACT OF AGENCY): This model is used in the middle-east region where takaful provider plays the role of an agent. He is not the owner of the fund but merely a trusted custodian. He manages the takaful or retakaful fund i.e. “reinsurance fund” by charging a fee for the services provided. In the wakalah model, the participants are the policyholders who receive the profits in full. Also takaful insurance under this model is seen a method of risk management as opposed to conventional insurance where parties are risk takers. In addition to this, there is strict monitoring to make sure that the profits are invested in shariah compliant instruments and prohibits investment in banking sector and other industries which doesn’t fall under Islamic shariah, for e.g., cigarettes, alcohols or gambling. 3. COMBINED CONTRACT (HYBRID MODEL): It is the combination of Mudarbah and Wakalah model, under which the takaful provider (from wakalah model) performs the function of an agent who is responsible for the writing and documentation of the documents. On the other hand, takaful manager (from the mudarbah model) makes the investment decisions. This model is gaining popularity and in Bahrain and Malaysia it is compulsory to use this model in many markets and industries. 4. WAKALAH WAQF CONTRACT: This model is particularly used in Pakistan, in which the initial funds or donations are collected from the shareholders. After collecting the funds, takaful funds are managed through combined model in which the relevant parties are the policyholders, takaful provider and the takaful manager. However, Qard Al-Hasan (interest-free loan) is not given to policyholders to support their funds. The above four models of takaful contracts used widely in the Muslim world. Along with these models, some other models like Musharaka model, kafalah model, Ju`alah model, al-Salam model etc, also provide solutions to conventional insurance methods. J. THE WAY FORWARD: Takaful insurance has provided business solutions to the Muslim world therefore; the chances for the growth of the takaful business are very promising. Takaful products are available in many countries which meet the needs of the corporations and individuals. Malaysia was the first country to introduce takaful Act 1984 to make laws and regulations about takaful insurance, which differs from traditional insurance acts and ordinances. Also Pakistan has introduced rules governing takaful policies. The takaful rules and regulations has increased public awareness about the takaful industry and the growth rate of the takaful industry in Srilanka, Bahrain and UAE has increased to 69, 52 and 47 percent, respectively. Over the years, the diversified distribution channels have contributed to the growth of takaful insurance outside the Muslim world. The proposed global target markets are Asia and middle east/Africa which have the huge potential because of the growing number of Muslim population. Since takaful insurance is an important component of Islamic Financial system, therefore, takaful companies have to work very hard on product innovation and customer service in order to attract large segments of the market. However, the biggest challenge is to overcome the shortage of resources especially, human resources; by providing training and development to employees about Islamic banking and financial models and retaining highly competent employees who can contribute to the growth of takaful industry. REFERENCES: 1. ICMIF, 2011. Takaful insurance. [Online] Available at: [Accessed 30th April 2011]. 2. Ernst & Young, 2010. The World takaful report 2010. [Online] Available at: [Accessed 30th April 2011]. 3. Qaisar, M., 2008. Takaful - the Islamic insurance. Published in, “the insurance times”, 2008. 4. Khairunissa, N., 2007. Comparison between takaful and insurance. [Online] Available at: . [Accessed 1st May 2011]. 5. Islamic Financial services board, 2006. Issues in regulation and supervision of takaful (islamic insurance). [Online] Available at: [Accessed 1st May 2011]. 6. Khan, A.A., 2003. Difference between Islamic and conventional insurance. [Online] Available at: . [Accessed 1st May 2011]. 7. ICMIF, 2011. Why is conventional insurance not permissible in Islam? [Online] Available at: >. [Accessed 1st May 2011]. Read More