Introduction

Sharia perspective on conventional insurance

Takaful – the Islamic alternative

Takaful models

Types of takaful policy

The future of the takaful industry

Conclusion

INTRODUCTION

Human beings have long recognised the need to protect themselves against the impact of risks they face, such as natural disasters, travel accidents, unemployment, sickness or dying at a young age and leaving a vulnerable young family behind.

Islam teaches its followers to put their trust in God; at the same time, it also encourages them to use the resources, skills and abilities bestowed on them by God to act responsibly and protect their wealth and property.

In this chapter we will look at the reasons why conventional proprietary insurance is not regarded as sharia-compliant and explore the Islamic alternative called takaful.

SHARIA PERSPECTIVE ON CONVENTIONAL INSURANCE

In conventional proprietary insurance schemes, a commercial entity seeks to provide insurance cover for a particular risk by charging an insurance premium and make a profit net of any claims and other costs. This model is at odds with the sharia in three key respects:

Gharar (excessive uncertainty)

Insurance aims to provide protection against an event that could happen but is uncertain in terms of if or when it might happen. Actuaries model the probability of events occurring and seek to set insurance premiums at a level that both compete effectively in the market and maximise profit for the insurance company. These attempts to model the future will invariably be imperfect. Some uncertainty will exist in almost all commercial dealings (for example, when a consumer buys fruit, there is a chance that it will not be ripe). This level of uncertainty is seen as natural and accepted in the market. However, the sharia does not tolerate ‘excessive’ levels of uncertainty (gharar) and most scholars are of the opinion that the uncertainty found in commercial insurance contracts falls into this category.

Maysir (betting)

Related to the fact that the occurrence of certain events is uncertain, sharia scholars are generally of the opinion that the premium charged by commercial insurance companies is similar to placing a bet (maysir) on whether a particular event will happen. So this is another sharia objection to conventional proprietary insurance.

Riba

In conventional insurance schemes, either the policy holder will receive more than they pay as a premium (if a successful claim is made) or the insurance company will receive more in premiums than it pays out in claims. Given that the ultimate outcome is a money-for-money exchange, i.e. a premium paid in money is exchanged for a potential payout in money later, and that these two values will invariably be different, in a commercial context this would amount to riba. Riba can also arise if the insurance company invests in interest-bearing instruments such as gilts.

TAKAFUL – THE ISLAMIC ALTERNATIVE

Takaful means mutual cooperation or joint guarantee. It refers to a not-for-profit set-up in which individuals club together by contributing into a common pool. The monies in this fund are used to pay out to members of the pool who have been afflicted by certain events that the members have mutually agreed to cover each other for – travel accidents, for example. The monies left in the pool after paying claims belong to the members.

The Takaful Act enacted by Malaysia in 1984 defines takaful as follows:

A scheme based on brotherhood, solidarity and mutual assistance, which provides for mutual financial aid and assistance to the participants in case of need whereby the participants mutually agree to contribute for the purpose.

The sharia violations of riba, gharar and maysir that are prevalent in conventional commercial insurance contracts do not occur in such a system. Instead of a premium payable in a commercial insurance contract, pool members donate (tabarru means donation) a sum of money to the pool. If a member is paid compensation from the pool, this payment is regarded as a form of mutual assistance rather than as a countervalue paid under a contract of exchange. Hence the issue of riba does not arise in such a system.

Similarly, the non-commercial nature of the arrangement means that the prohibitions of gharar and maysir do not apply. It is in a commercial context that the sharia demands as much certainty as possible in the exchange between the two parties to a transaction (i.e. absence of gharar) and forbids gambling/betting (maysir) by either party.

Takaful also differs from commercial proprietary insurance with regard to who bears the risk. In commercial proprietary insurance the risk is transferred to the insurance company, which takes on the risk(s) covered in the insurance policy in exchange for the insurance premium. Under the takaful system, risk is not transferred to any third party but is borne by and distributed among the members of the pool.

The relationship between the pool members and the pool is framed in terms of two binding promises: the members promise to contribute to the fund, and the pool promises to pay out in the event of a claim.

The takaful system is virtually identical to the concept of mutual insurance, which is still alive today and has a deep heritage in the United Kingdom, rooted in local communities putting money into a common pool to protect members from certain misfortunes.

It is worth noting at this point that in markets such as the United Kingdom, the provision of takaful products is limited. Where the law demands protection (for example, car insurance is required to drive a car in the United Kingdom) and there is no sharia-compliant alternative available, scholars have permitted the use of conventional insurance products. This is based on the fact that it is a legal requirement of the country and Islamically it is of paramount importance to be law abiding and maintain social order and harmony in society. Where there is no legal imperative but there is no sharia-compliant alternative available, scholars are reluctant to permit the use of conventional insurance products, but depending on the circumstances of a particular case, may endorse it if it is deemed that the potential loss to the person/entity will be very hard to recover from.

TAKAFUL MODELS

Takaful could in theory be established by governments or by privately organised groups and communities. In reality, given the range of risks that potentially requires covering and the fact that different risks apply to different groups of people, it is difficult for governments to provide the necessary range and depth of coverage. Therefore takaful solutions have tended to be established by private organisations.

Single entity structure

A single non-profit entity can be set up on a mutual or cooperative basis. This is almost identical to a mutual organisation in the United Kingdom, in which the entity is owned by members and there are no external shareholders seeking to make a profit from its activities. Members appoint a board or management to run the operation. The cost of management and other expenses are funded through member contributions and other activities such as profits earned from investments. Any surplus, net of claims paid and expenses, belongs to members. Any shortfall needs to be covered by increased contributions from members.

Double entity structure

An alternative and more common approach to takaful operations is to establish a two-tier structure (see Figure 8.1):

• Entity 1: a takaful mutual fund/pool operating on a non-profit basis to collate members’ funds and pay out to them on the incidence of certain events covered by the fund. The monies in the pool, including any surplus, belong to the members.
• Entity 2: a commercial entity, usually referred to as the takaful operator (TO), engaged by the takaful fund to manage activities such as claims handling and investments in accordance with sharia principles. The commercial entity is motivated by the revenues it can earn for shareholders from services provided to the takaful non-profit-making entity. The TO has no direct liability in respect of any takaful policies issued by the fund – it is merely entrusted to manage the takaful entity and its investments.

A common feature of the relationship between the TO and the takaful fund is that the operator agrees to provide an interest-free loan (qard hassan) to the fund in the event of a shortfall in the fund due to claims exceeding member contributions.

Figure 8.1 Takaful models: single entity structure versus double entity structure

Possible pitfalls of the double entity structure

Most takaful operations around the world have been set up based on the double entity structure, and have usually been initiated by takaful operators who have identified a commercial opportunity in providing sharia-compliant protection.

There are some potential pitfalls with this structure:

1. Takaful is in essence a non-profit-making activity, set up for the mutual protection and benefit of its members. The takaful fund must ensure that its original purpose and values are not undermined by the involvement of a commercial entity focused on maximising profit. Close attention needs to be paid to how the commercial entity is remunerated, so that its interests are fully aligned to those of the takaful fund. We will look at this more closely when discussing how the relationship between the TO and the takaful fund can be structured.
2. Some commentators have argued that the agreement by the TO to provide an interest-free loan to the takaful fund in the event of a shortfall is tantamount to transferring risk from the takaful fund to the TO. Such a transfer would be fundamentally at odds with the concept of takaful – that risk needs to be shared and distributed among members of the takaful fund and not transferred to a third party.

Relationship between the takaful pool and the takaful operator

As described above, the operator provides services to the pool. These services fall into two broad categories:

1. Underwriting – this includes issuing new takaful policies and claims handling. These services are typically provided by the operator to the pool through a wakala contract (principal–agent relationship). The operator acts as the agent (wakil) of the pool members (the principal) and receives a fee for its underwriting services on this basis. This can be structured as a fixed fee or as a percentage of the contributions paid into the pool.
2. Investment management – this refers to investing the monies of the takaful pool on behalf of the pool members. A mudarabah contract for the investment management services is typically provided by the operator. The operator acts as the mudarib, providing investment management services to the pool members, who collectively form the rabb-ul-maal (providers of capital). Under such a contract, the operator does not receive any fixed remuneration, instead sharing in any profit generated through the investment activity, while any losses are borne solely by pool members.

The wakala contract for underwriting services and the mudarabah contract for investment management services is the most common model used to define the relationship between the TO and the takaful pool and its members. There are a number of reasons for this:

• The wakala contract lends itself well to the provision of underwriting services as a management fee is charged to the pool by the TO. This is usually either a fixed fee or a percentage of the value of contributions received by the pool (this can be justified on the basis that the greater the value of contributions, the more work the operator needs to do).
• Applying a mudarabah (profit-sharing) contract to underwriting would not work as well for the following reasons:
  • The essence of takaful is that any underwriting surplus should belong to the pool members, as they are and should be the ‘risk takers’. If the operator shares in the surplus, its role as a ‘risk manager’ starts to merge wrongly into ‘risk taking’.
  • An underwriting surplus is not the aim of the takaful pool and is not the same as a profit – it is in fact an undistributed surplus from the tabarru. Hence to apply a contract of profit sharing is something of a mis-fit.
  • Similarly, if the operator is remunerated according to the value of the underwriting surplus, the operator will be motivated to maximise the surplus. This is not aligned to the interests of the pool members, nor is it compatible with the aims and values of takaful.

Yet the mudarabah contract is well suited to the investment management activities of the TO. The operator receives a share of any profits from the investments and hence the operator’s interests are generally aligned to those of the pool members – to make the best possible return. However, there is the potential misalignment of interests if the operator wants to take more risk than is suitable for the pool members. Such issues need to be addressed in the governance applied to takaful operations.

Nevertheless, it is also possible to use a wakala contract for investment management services, instead of the mudarabah contract. The fee payable to the operator (wakil) can be structured to contain a performance-related component. The mudarabah contract is generally more risky from the operator’s point of view as no remuneration will be received unless a profit is made on the investments. Hence either wakala or mudarabah contracts could be used for investment management services: the contract chosen depends on the preferences of, and agreements between, the TO and the pool members.

Use of the waqf (endowment) concept in takaful

A waqf is an endowment created by a person who donates an asset that they own to an endowment vehicle, with the intention of benefiting specified beneficiaries. The donor can still manage the asset or may pass management responsibility to other specified persons. In the United Kingdom and other jurisdictions, where specific waqf legislation does not exist, trusts can work well as an endowment vehicle.

The use of the waqf concept has been increasingly applied within the takaful arena. In Pakistan, for example, a waqf takaful model has been used. The waqf founder initiates a takaful operation by donating a sum of money to the waqf. Participants then contribute to the waqf with the objective of paying out and helping participants who are affected by specified events or risks.

In this kind of scheme, all investment returns and any underwriting surplus remain within the waqf and are not shared with the contributors. The participants at the outset agree that any surplus should be kept and used by the charitable waqf. A waqf may appoint external providers to supply services such as investment management.

A more common model is to combine a waqf with a wakala contract, and in some circumstances with mudarabah as well. For example:

• A takaful operator provides underwriting services on a wakala basis.
• The operator also provides investment management services on a mudarabah basis.
• Any surplus generated by the takaful pool is donated to a waqf, instead of being redistributed back to pool members.

Using a waqf in this way can help to mitigate a practical issue of redistributing surpluses back to members. Insurance is a dynamic activity with a continuous stream of joiners and leavers and new claims. Moreover, claims can sometimes be made some considerable time after the incident giving rise to the claim has occurred. As a result, accurately ascertaining what proportion of the surplus a member is entitled to can be difficult. This issue is resolved if all members agree that any surplus should be paid to a charitable waqf.

TYPES OF TAKAFUL POLICY

Conventional insurance is broadly categorised into life insurance and general insurance. In a similar way, takaful can be broadly categorised into general and family/life takaful.

General takaful

General takaful, like general insurance, seeks to cover losses suffered by replacing value equivalent to that prior to the damage or loss. The risks covered are generally short-term in nature, such as protection against car accidents, travel problems, fire, damage to property and so on. Within this space, protection for businesses such as professional indemnity, employer liability and public liability cover are all possible. General takaful policies usually last one year and focus almost entirely on protection as opposed to investment return and growth. Hence the activities of the TO or the mutual takaful pool are centred around underwriting.

Family/life takaful

Takaful can cater for all risks, including death – to provide assistance to the family of the deceased is very much in line with Islamic values. Family/life takaful plans are generally schemes that provide cover to an individual who wishes to save a sum of money for dependants, should the participant die prematurely. This cover is effectively a long-term savings plan, typically of 10–30 years’ duration. Given the long-term savings nature of these policies, contributions by participants are usually split into an underwriting pool and an investment pool. If the participant dies during this period, the policy provides some financial protection for the family and dependants left behind; otherwise the policy matures at the end of the contracted period.

Such policies can also usually be redeemed at any time up to maturity. Family/life takaful therefore goes beyond simply insuring against the event of death; it also enables the participant to save a capital sum on survival.

There are three typical scenarios:

1. Death before plan matures: heirs to the deceased’s estate receive all of the monies accumulated in the investment pool based on the deceased’s contributions into the pool and the returns earned on those contributions. In addition, the heirs will receive from the underwriting pool an amount of money equivalent to all remaining or outstanding total donations that would have been made if the participant had survived until maturity of the takaful plan.
2. Benefits at maturity: if the participant survives until maturity of the plan, he or she will typically receive the monies accumulated in the investment pool (as above) plus a proportion of the surplus, if any, arising in the underwriting pool.
3. Surrender benefit: this arises when a participant decides to terminate his policy before maturity. Typically he or she receives monies accumulated in the investment pool on his behalf, but does not receive any monies from the underwriting pool.

It is possible to provide takaful such that a person’s family receives a payout on death, whenever that occurs, i.e. like a conventional whole-of-life policy. This is rare because life cover is invariably a long-term policy; in takaful, the monies in the pool belong to the members and hence this is suited to a plan in which the member benefits from investment and underwriting services.

Retakaful

As with conventional insurance, the takaful pool needs to be able to redistribute some of the risk outside the pool if it is to remain viable and sustainable. Otherwise, very large claims resulting from catastrophic events (such as heavy storms or flooding) could cause the pool to become insolvent. Consequently, retakaful has developed in a similar way to reinsurance.

The takaful pool redistributes some of the risk in the pool by passing a portion of the contributions in the takaful pool to the retakaful pool. The retakaful pool works on the same principles as takaful: the members of the retakaful pool (other takaful pools/funds) make contributions into the pool to mutually guarantee each other (see Figure 8.2). The participants in a retakaful contract are the takaful operators, acting on behalf of the respective takaful pools they represent.

Figure 8.2 The retakaful pool

THE FUTURE OF THE TAKAFUL INDUSTRY

A report by Ernst & Young in 2013¹ commented that ‘there is a dearth of takaful operators who are capable of providing leadership to the growing internationalisation of the industry. There is a need for large, regional champions to lead growth in regional markets and to participate in international markets’.

There are signs of change. In this 2013 publication, Ernst & Young reported that global gross takaful contributions are estimated to be around $15 billion in 2014, growing at more than 15 per cent per annum.

Momentum seems to be building in takaful’s three key markets – Saudi Arabia, Malaysia and UAE. Saudi Arabia accounts for approximately half of the Islamic insurance industry, partly due to the fact that conventional proprietary insurance is not permitted in the country. The growth lever for strong growth in Saudi Arabia and UAE (specifically Abu Dhabi) was the implementation of the compulsory national health insurance policy. Qatar is also legislating to make it mandatory to hold a national health insurance policy, which will drive demand of its takaful industry. Malaysia, with a relatively developed Islamic finance industry, has actively supported the growth of its takaful sector. In fact, Malaysia has emerged as the world’s largest family takaful market. With a proven model and regulatory clarity, the country is set to further build on this leadership position. Family and medical takaful are the major business lines across all markets.

Scale in the protection space is very important and this has been a challenge outside of Saudi Arabia and Malaysia. Regulatory enhancements are also presenting new opportunities in rapid growth markets such as Turkey and Indonesia. The challenge is to build on the lessons learned from core Islamic finance markets to address rising demand expeditiously.

CONCLUSION

Takaful is in many ways the ‘sleeping giant’ of the Islamic finance industry. As highlighted at the beginning of this chapter, protection against the risks we face as human beings is a basic need. With the significant and growing Muslim demographic across the world, a tremendous opportunity exists to provide sharia-compliant protection solutions. Conventional insurance still dominates across the Muslim world (in a report by Swiss Re in 2011, 83.1 per cent of premiums went to conventional insurance providers in Muslim countries²) and in most of the non-Muslim world there is very little provision of takaful.

For the takaful industry to compete with conventional proprietary insurance, it needs to achieve scale, a more accessible regulatory framework, have suitable long-term investments for the family/life takaful market and attain operational efficiency. Scale is important to overcome significant start-up costs, provide competitive pricing and mitigate the risk of insolvency. Regulation in individual jurisdictions and the regulatory framework across borders need to be simplified to allow larger, regional players to develop. A lack of relatively stable, long-term sharia-compliant investments has been an issue – these are needed to match the long-term nature of family/life takaful plans and the fact that these plans have a strong investment focus. Instruments such as longer-term sukuk are required to support the growth of the takaful industry. World-class standards of operational efficiency are required to compete effectively with the well-established conventional insurance market.

An oasis of opportunity exists in the takaful market, but if the growth potential is to be realised, a significant number of challenges need to be overcome.

¹ Ernst & Young (2013) ‘Global Takaful Insights 2013: finding growth markets’.

² Islamic Finance News (2012) Supplement, May.