Chapter 18

Takaful: Exploring the Fundamentals of Islamic Insurance

In This Chapter

Realizing why Muslims avoid conventional insurance products

Recognizing the principles, features, and structures of takaful

Considering the origins and growth of the Islamic insurance industry

Whether you’re a student or a retiree, a businessman or an investor, you face financial risks every day. You may go on vacation and come back to find that your house has been stripped of your most valuable possessions — or that your luggage somehow didn’t make the return trip. You may start a business with a solid plan and then watch the global economy nosedive, taking with it your ability to make your loan payments, keep up with utility bills, and pay your staff. You may crash your car, smash your finger, or lose your wedding ring. I can go on and on, but I sense your blood pressure rising already!

A broad spectrum of conventional insurance products is available to mitigate whatever fiscal risks take your blood pressure into unsafe territory. However, for Muslims, such products are generally off-limits because they involve transactions or activities that sharia (Islamic law) prohibits.

Your Muslim neighbor or co-worker is like you: He doesn’t want to lie awake at night sweating and fretting about what will happen if his house is robbed or his new business venture doesn’t succeed. He wants the comfort of knowing that his life won’t fall apart if a certain risk turns into reality.

For that person and for the entire Muslim community — plus anyone else who’s interested, too — a new spectrum of insurance products has emerged in recent decades. These products, referred to collectively as takaful, are based on principles, features, and structures that set them apart from conventional insurance. In this chapter, I offer a big-picture overview of what takaful are all about. (Be sure to check out Chapter 19 for a detailed rundown of the most common takaful products.)

Appreciating the Need for Takaful

You may wonder why takaful are necessary. What’s wrong with the insurance products offered by State Farm, Allstate, Liberty Mutual, and the rest?

First, let me clarify that the issue is not that insurance products reduce risk. Years ago, before takaful appeared on the market, many people in the Muslim community believed that trying to reduce risk went against Islam. Their perception was that because every worldly action comes from Allah’s will, people shouldn’t try to reduce or avoid the results of those actions.

However, although Islam does prohibit attempting to avoid risk altogether, it doesn’t prohibit reducing risk. Consider this story from a book of hadith (sayings attributed to the Prophet Muhammad [pbuh]) called Al-Tirmidhi.

One day Prophet Muhammad (pbuh) noticed a bedouin (a desert dweller) leaving his camel without tying it, and he asked the bedouin, “Why don’t you tie down your camel?” The bedouin answered, “I put my trust in Allah.” The Prophet then said, “Tie your camel first, then put your trust in Allah.”

This story clearly indicates that everybody should take care to reduce personal risk. And if Muslims aren’t forbidden from trying to reduce risk, what’s the rub with conventional insurance? The elements of uncertainty (gharar), gambling (maysir), and interest (riba) make conventional insurance products prohibited risk-sharing instruments for Muslims.

Lacking certainty

Conventional insurance is a contract between the insurer and the insured, but this contract doesn’t explicitly describe its outcome for either the insurer or the insured. And sharia doesn’t allow the sale of contracts that are based on uncertainty. The conventional insurer has the assurance of receiving a premium each month but faces uncertainty regarding when and whether the insured will make a claim. Likewise, the insured may or may not incur losses or damages to prompt a claim.

In addition, when an insurance claim does occur, neither party knows in advance how much may be paid to the insured (or even whether the insurer will pay a cent). The insurer considers many variables when documenting an insurance claim, so predicting what the outcome may be for either party is impossible. The bottom line: Islamic scholars agree that conventional insurance contracts are based on uncertainty, which means they aren’t sharia-compliant.

Gambling with premiums

Going hand-in-hand with uncertainty is the fact that conventional insurance has characteristics of gambling. The conventional insurer receives huge amounts of money from the insured in the form of premium payments. Will the insurer be able to hold onto that money? Or will some sort of disaster strike (tornado, wildfire, flood . . . pick a weather event) that results in the insurer paying out every dime of the premiums and then some? When few claims are filed, the insurer wins (and the insured lose their premiums). When loads of claims are filed, the insured get some payback for their premiums (and the insurer may be in trouble).

Some people argue that conventional insurance isn’t the same as gambling because gambling is a speculative risk (made based on a conscious decision) and insurance covers pure risk (events that are out of someone’s control). Further distinguishing the two is that a gambler may win or lose, whereas someone carrying insurance doesn’t ever really win; the insured always lose but at least get their loss (or part of it) covered. That said, most Islamic scholars don’t split these hairs. They generally agree that conventional insurance products involve gambling and aren’t sharia-compliant.

Collecting interest

Another reason that Islamic law prohibits conventional insurance products is that their transactions involve interest. Interest generally comes into play in two ways:

Insurance companies need to make sure they can pay their customers’ potential future claims, so they rarely let the premiums they collect sit in a cash account. Instead, they invest the premiums in interest-bearing fixed income instruments such as conventional bonds.

If the insured files a substantial claim, she may receive an amount from the insurer that totals more than the premiums she has paid. Most Islamic scholars consider any excess amount paid by a conventional insurer to be interest.

Keep in mind that someone who purchases a takaful product can also receive an amount that exceeds the total contributions she pays in. In that case, the excess amount is not considered interest. The difference is not just semantics; the difference lies in the structure of a takaful fund and the transfer of risk (which is quite distinct from a conventional insurance product). These are topics I explain in this chapter. For now, just know that someone participating in a takaful product can receive a payout that exceeds what she has paid in.

Exploring Takaful

Not long ago, scholars involved in developing the Islamic banking system (see Chapter 3) also recognized the need for Islamic insurance. The origins of takaful products are actually ancient, but the modern Islamic insurance system started in earnest only in the late 1970s. (See the later section “Examining the Evolution of Takaful” for an overview of how and when the modern Islamic insurance system emerged.)

The word takaful comes from the Arabic root kafala, which means “guarantee” or “mutually guaranteeing.” Although many people (myself included) may refer to takaful as Islamic insurance, the term more accurately indicates a mutual or joint guarantee.

Theoretically, a takaful is a common pool of funds that members contribute to in order to share a certain risk and to help each other (not to make a profit). In the real world of commercial practice, this definition may be tweaked to accommodate various takaful structures. I discuss those structures in this section, but first I explain other big-picture aspects of takaful: the principles that support it, the people involved, and the features that define a takaful product. In doing so, I also draw some clear lines between takaful and conventional insurance products so you can see how they differ.

Grasping the principles behind takaful

Takaful is a form of mutual insurance based on the principles of cooperative risk sharing, mutual responsibility, mutual protection, and solidarity among groups of participants. Each takaful model (structure) may combine these principles in different ways, but a takaful product always is rooted in these four.

Cooperative risk sharing

One of the main principles of takaful is cooperative risk sharing. A takaful participant contributes to the money pool and receives help from that pool (by the funds coming from other members) when a risk becomes a reality.

In conventional insurance, risk is transferred from one party to another. By taking out an insurance policy, an individual essentially is asking the insurance company to accept the complete risk (in exchange for accepting an ongoing premium from the insured). But with takaful, the risk is shared among the members of the fund: If an event occurs that causes harm or damage to one member, all members bear the brunt of that event and contribute to overcoming it. Takaful members cooperate based on equality, solidarity, social responsibility, and honesty.

Although a conventional insurance policyholder pays ongoing premiums, a takaful participant makes ongoing contributions — considered gifts or donations for sharia purposes (for takaful contracts) — to the takaful fund pool. The amount of the contribution differs depending on the type of coverage a participant needs and how long he needs coverage.

Takaful participants are entitled to share any surplus that may exist in the pool at the end of the financial year. Similarly, the takaful participants need to make additional contributions to cover deficits in the fund (in theory, at least; takaful companies rarely ask participants to make deficit contributions). I explain surplus and deficit situations in the later section “Identifying the parties involved.”

Mutual responsibility

The purpose of takaful is not (or, at least, not only) for participants to make a profit. Instead, takaful are based on mutual assistance among members; each member in the fund is responsible for alleviating the misfortunes of the other members. The member of a takaful fund shares the risks of all other members. Put another way, every member’s risks become the mutual responsibility of all other members.

For example, consider two individuals who each contribute to a property takaful product. One person may own a commercial property and need the coverage in case that building is damaged or destroyed. The other person may seek coverage for his home. When they agree to participate in the fund, both the commercial building and the residence become the mutual responsibility of both participants.

Mutual protection

Another important principle of takaful is mutual protection among the members of the fund. Each member participates in protecting all the other members against loss or damage. This principle has been practiced at least since the time of the Prophet Muhammad (pbuh). In the later section “Examining the Evolution of Takaful,” I describe how ancient tribes created a blood money system that offered such protection to every tribe member.

Solidarity among participants

Any time you willingly participate in a group, you likely experience some solidarity with the other members. People who choose to contribute to a takaful fund share common interests (the desire to protect themselves and all other members from harm deriving from loss or damages) and common responsibilities (sharing the risks involved with the fund and the responsibility of alleviating other members’ misfortunes).

Identifying the parties involved

The following groups and individuals are directly involved with the business of takaful:

Stockholders (shareholders): Stockholders are the owners of a takaful business enterprise — the folks who provide the capital to start the business. A takaful company, like any other company, requires management and incurs administrative, marketing, and other operating expenses. The stockholders cover such expenses at the time of startup and (as needed) for the life of the fund.

In exchange for their investments, stockholders are paid explicit fees on an ongoing basis. (Policyholders may pay fees to cover this ongoing fund expense.) In addition, stockholders receive a cut of the company’s profits on an ongoing basis. So even though (in theory) takaful funds don’t exist for the purpose of making a profit, for practical reasons a fund certainly tries to make a profit (so it can reward its investors).

Takaful operator: Although stockholders set up the takaful company and provide the upfront cash, a limited liability company called a takaful operator actually manages the fund. Takaful operators are financial institutions, and they have expenses related to staffing, administration, marketing, and so on.

The difference between a takaful operator and a conventional insurance company lies in the business model. In conventional insurance, members or policyholders don’t participate in an insurance fund, so an insurance company’s primary jobs are to invest premiums, investigate claims, determine appropriate payouts, and — above all else — maximize profits. In contrast, the takaful operator’s primary job is to manage the policyholders’ fund.

Policyholders (takaful fund contributors): These people make contributions (referred to as gifts) to the fund’s pool of money and mutually share the risk inherent in the fund. Keep in mind that even though the contributions are considered gifts or donations, they aren’t optional. If someone wants to participate in a takaful fund, these contributions are mandatory.

A policyholder has the right to receive a share of any fund surplus that exists at the end of the financial year. The company determines that surplus amount (if any) after paying all its expenses (including any pol-icyholder claims) and distributing profits to the stockholders. Then the takaful operator exempts or lowers the amount of contributions from the policyholders in the following period or year. After a year during which relatively few claims are made against the takaful fund, a surplus is likely to exist, so policyholders can expect their fund contributions to be lower the following year. After a year during which many claims are made, policyholders likely will owe their full contribution amounts the following year.

As I note earlier in this chapter, although policyholders theoretically need to pay more to the pool when a fund runs a deficit in a given year, most takaful funds don’t actually require that. Instead, if a deficit occurs, the fund’s stockholders (not its policyholders) alleviate the deficit by offering the fund an interest-free loan (based on a qard hasan contract). The following year, the company is expected to pay back this loan and deduct the amount from any surplus it has in that financial year. If the takaful fund runs deficits for two or more years in a row, participants should expect their contribution amounts to increase in subsequent years.

Sharia board: A takaful company must have a sharia board (a group of Islamic scholars dedicated to determining compliance with Islamic law) that supervises its operations. The sharia board makes sure the company is making sharia-compliant investments, approves new products, and determines whether the business activities are sharia-compliant. Flip to Chapter 16 for details on sharia boards.

Noting key features of takaful

In addition to the four principles of takaful I discuss earlier, takaful have other key features that set them apart from conventional insurance products:

The takaful company exists for reasons other than to profit its stockholders. In conventional insurance, the insurance company exists to maximize its profits; that’s the primary goal. The insurance company belongs to the shareholders, and they’re the sole owners of any profits generated by policyholder premiums.

Takaful is based on a different model. As I note earlier in this chapter, in theory, profit isn’t the goal of a takaful fund at all. (In reality, making a profit is helpful because it serves as part of the stockholders’ reward for investment.) Instead, the focus of a takaful fund is squarely on helping its members share their risks, thereby potentially reducing the risk facing any one individual member.

Takaful stockholders are paid fees in addition to a share of profits. Just like the shareholders in conventional insurance companies, takaful stockholders expect to be rewarded for their investments. Investors in conventional insurance companies receive dividends (whose amounts are unknown until the company’s profits are determined for a given financial quarter); takaful stockholders are paid an explicit fee from the fund in addition to getting a share of any profit. This explicit fee covers the setup costs as well as the operating expenses and investment-related expenses that the stockholders provide on an ongoing basis.

Takaful companies must make sharia-compliant investments. The funds in a takaful company need to be invested in sharia-compliant ways. I devote Part IV to a thorough discussion of sharia-compliant investment options, including equity funds and sukuk (the Islamic alternative to conventional bonds).

Takaful companies are governed by a sharia board. As I explain in the preceding section, a takaful company (like all other Islamic financial institutions) must have a sharia board that supervises company operations and approves new product developments.

Here are the most significant ways in which takaful products, unlike conventional insurance, achieve sharia compliance:

Contributions by policyholders are considered gifts, not premiums. These gifts are used by the takaful fund to help members who need assistance.

Policyholders join the pool and cooperate among themselves for their common good.

Policyholders don’t financially benefit from other policyholders’ money. They benefit by recouping expenses related to loss or damage but not by pocketing cash that comes from other policyholders’ contributions.

When a takaful company invests any of the funds it collects from its policyholders, it selects only sharia-compliant investment vehicles.

The entire takaful operation takes place without the involvement of interest. Stockholders don’t receive interest payments for their investments, and the company doesn’t accrue interest on its investments.

Introducing takaful structures

The basic takaful structure involves pooling the contributions offered by policyholders and sharing the funds among those contributors when needs arise. In practice — at least in the commercial world — a pure takaful structure doesn’t exist; policyholders don’t just magically gather together and volunteer their money to start a fund.

Instead, takaful products are usually built on one of three structures that use two primary Islamic contracts as their foundation. In Chapter 19, I offer a detailed look at these commonly used takaful structures (including figures that help you visualize the flow of money and risk). Here, I briefly introduce them:

Principal-agent relationship (wakala) model: In this takaful structure, a limited liability company represents its policyholders in order to manage their funds. (The policyholder is considered the principal, and the takaful operator is the agent or wakil.)

Partnership (mudaraba) model: Here, the takaful policyholders act as the investing or silent partner (rab al mal), and the takaful operator is the working partner (mudarib).

Combination of principal-agent and partnership (combined) model: Both the wakala and mudaraba contracts are used for two different sets of activities: managing the takaful fund and investing the takaful fund. In this scenario, the takaful operator acts as both the agent (wakil) and the fund manager (mudarib) for the fund. The takaful operator manages the fund based on the wakala contract and invests the fund based on the mudaraba contract. This method is the one most frequently used by modern takaful companies.

Table 18-1 gives you a snapshot of the key differences between takaful and conventional insurance.

Table 18-1 Contrasting Conventional and Islamic Insurance

	Conventional Insurance	Takaful
Contract on which the product is based	A basic sales contract is in play. The insurance company is the seller, and the insured is the buyer.	The contract used (wakala, mudaraba, or a combination of the two) depends on the model of takaful that the company selects.
Transfer of risk (who’s responsible for policyholder risk)	Risk transfers between the policyholders and company. The insurance company provides protection risk to its policyholders in exchange for an insurance premium. No relationship exists among the policyholders or between the company and a policyholder.	Risk is shared among the policyholders. The takaful pool, not the company itself, provides protection for policyholders. The company just manages the business. Each policyholder shares all other policyholders’ risks.
Nature of company investments	The investment of premiums is unrestricted.	The company makes only sharia-compliant investments.
Who gets the surplus	The entire surplus belongs to the company and is distributed among stockholders.	A portion of the surplus must be shared among the policyholders.
Who is responsible for excess liability	The insurer needs to pay from its own assets and from owners’ equity to cover excess liability.	In theory, the policyholders must pay any excess liability. (In reality, stockholders usually make an interest-free loan to the company to cover this expense.)

Examining the Evolution of Takaful

The birth of takaful goes back to the early days of Islam (which I discuss in Chapter 3). During the lifetime of the Prophet Muhammad (pbuh), the people of Mecca (Makkah) and Medina (Madinah) in what is now Saudi Arabia practiced a mutual insurance system called aqila. Here’s how the system worked: If a person from one tribe killed a person from a different tribe, the killer’s tribe was on the hook to pay blood money to the deceased person’s family. All tribe members were expected to contribute to the aqila system, so it was essentially a fund pool that paid blood money when someone was killed.

Scholars believe that the core concept of modern takaful was first introduced by merchants who traded among the Persian Gulf, Asia, and South Asia in the ninth century. The concept they introduced was that groups of people would pool their funds and agree to share the risk of misfortunes such as robberies and natural disasters. However, no record indicates that takaful existed between the 9th century and the birth of modern takaful in the 20th century.

Modern takaful emerged because Muslim scholars actively sought an alternative to conventional insurance, which isn’t sharia-compliant. These scholars were witnessing and/or participating in the development of modern Islamic banking, and the insurance question was a logical one to consider.

From the beginning of the 20th century through the end of the 1970s, Islamic high authorities made periodic religious decisions that opened the door to the possibility of an Islamic insurance industry. Starting in the late 1970s, the industry as it exists today began to emerge. See the nearby “Following the timeline of takaful” sidebar for details on this evolution.

Eyeing the Future Growth of the Takaful Industry

Takaful is still in its infant stage and occupies a niche market, but it’s the fastest-growing sector of the global insurance industry. One reason is that most countries require auto insurance coverage of some kind, and many nations (but not all) accept motor takaful as well as conventional auto insurance. Another reason is simply that various takaful products (which I detail in Chapter 19) have become available as sharia-compliant alternatives to conventional insurance.

The current takaful market is concentrated in Malaysia and the Middle East. An estimated 130 takaful companies are in business worldwide, and almost half of them are concentrated in the Gulf Cooperation Council (GCC) nations of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates.

Between 2004 and 2007, the takaful industry grew on average 25 percent per year. (The conventional insurance industry grew 10.2 percent per year during that time frame.) Worldwide in 2007, $1.7 billion in contributions were paid to takaful funds. According to A.M. Best’s Takaful Review published in 2011, that amount may reach $7 billion worldwide by 2015.

Despite such a rosy outlook for the industry, takaful operators are facing challenges presented by their higher costs (compared with those incurred by conventional insurers) because of their lower economies of scale. However, takaful companies have an important competitive advantage: customer loyalty, which is built on takaful’s sharia compliance.

As I outline in Chapter 4 and Chapter 20, the worldwide Muslim population is huge and growing rapidly. Plus, 60 percent of the global Muslim population is under 25 years old. If these young people buy into the value of participating in takaful funds, the takaful industry will soar.

The Western market is virtually untapped when it comes to takaful. Especially in Europe, where the Muslim population is quite substantial, the potential for takaful companies seems enormous. And even in Muslim countries such as Pakistan, Bangladesh, Indonesia, and Egypt, the takaful industry is so new that its potential has only begun to be explored.