What is Shariah based Life Insurance or Takaful and how it works

All human activities are subject to risk of loss from unexpected events. To alleviate this burden to individuals, what we now call insurance has existed since at least 215 BC. This concept has been practiced in various forms for over 1400 years. It originates from the Arabic word Kafalah, which means, "guaranteeing each other" or "joint guarantee". The concept is in line with the principles of compensation and shared responsibilities among the society.

Takaful originated within the ancient Arab tribes as a pooled liability that obliged those who committed offences against members of a different tribe to pay compensation to the victims or their heirs. This principle later extended to many walks of life, including sea trade, in which participants contributed to a fund to cover anyone in a group who suffered mishaps on sea voyages.

In modern-day conventional insurance, the insurance vendor (the insurance company) sells policies and invests the proceeds for the profit of its shareholders, who are not necessarily policyholders. There is therefore a clear disjunction between policyholders and shareholders. Payouts to policyholders may vary depending on financial performance, but a minimum positive return is always contractually guaranteed.

Takaful is commonly referred to as Islamic insurance; this is due to the apparent similarity between the contract of kafalah (guarantee) and that of insurance.


For some time conventional insurance was considered to be incompatible with the Shari’ah that prohibit excessive uncertainty in dealings and investment in interest-bearing assets; both are inherent factors in conventional insurance business.

However, takaful complies with the Shari’ah (which outlines the principles of compensation and shared responsibilities among the community) and has been approved by Muslim scholars. There is now general, health and family (life) takaful plans available for the Muslim communities.



Prohibitions of Gharar, Maysir and Riba:

Gharar:         An insurance contract contains gharar because, when a claim is not made, one party (insurance company) may acquire all the profits (premium) gained whereas the other party (participant) may not obtain any profit whatsoever. Ibn Taimiyah, a leading Muslim scholar, further reasoned "Gharar found in the contract exists because one party acquired profit while the other party did not". The prohibition on gharar would require all investment gains and losses to eventually be apportioned in order to avoid excessive uncertainty with respect to a return on the policyholder's investment.

Maysir:       Islamic scholars have stated that maysir (gambling) and gharar are inter-related. Where there are elements of gharar, elements of maysir are usually present. Maysir exists in an insurance contract when; the policy holder contributes a small amount of premium in the hope to gain a larger sum; the policy holder loses the money paid for the premium when the event that has been insured for does not occur; the company will be in deficit if the claims are higher that the amount contributed by the policy holders.

Riba:      Conventional endowment insurance policies promising a contractually-guaranteed payment, hence offends the riba prohibition. The element of riba also exists in the profit of investments used for the payment of policyholders’ claims by the conventional insurance companies. This is because most of the insurance funds are invested by them in financial instruments such as bonds and stacks which may contain elements of Riba.

Gambling and Insurance:

Gambling and insurance are two distinct and different operations. Gambling is speculative in its risk assessment whereas insurance is a pure risk and is non-speculative. In gambling, one may win or lose by creating that risk. In insurance, the risk is already there and one is trying to minimise the financial effects of that risk. Insurance shifts the impact of that risk to someone else and relieves the person of risk. The risk nevertheless still remains.

While gambling promotes dissension, ruin and hatred, insurance based on cooperative principles, enables the insured to lessen the financial impact without which it could drive the individual and his dependents to poverty, thereby weakening their place in the society. There is nothing in Islam that prevents individuals from making a provision for their dependents. Seen collectively for large groups of insured population, insurance strengthens the financial base of the society.

Islamic scholar, Yusuf Ali, in his translation of The Holy Qur’an, comments on Sura (chapter) Al-Baqara, ayat (verse) 219, "Insurance is not gambling, when conducted on business principles. Here the basis for calculation is statistics on a large scale, from which mere chance is eliminated. The insurers charge premium in proportion to the risks, exactly and scientifically calculated".

There are three main differences between a gambling and an insurance contract.
a) In a gambling contract, neither party has any other interest than winning a sum of money. The gambler is not being indemnified against any loss. But, in an insurance contract, the insured's right to be paid depends on his suffering loss from the insured peril. In other words, an insurance contract is a contract of indemnity, which is non-existent in a gambling contract.

b) In the case of gambling, one party must win and the other loses. In insurance, on the other hand, the event entitling the insured to compensation may or may not happen during the period of the policy, but he pays a premium for being protected during that time.
c) If a gambler wins, he gets back not only his original stake but also an additional amount without suffering any loss, whereas an insured person never gets back his premium and is only indemnified to the extent that he has suffered damage.
Basic and Principles of Takaful:

Islamic insurance requires each participant to contribute into a fund that is used to support one another with each participant contributing sufficient amounts to cover expected claims.

The underlying principles of Takaful may be summarised as follows:
Policyholders co-operate among themselves for their common good.
Every policyholder pays a part of the contribution as a donation to help those that need assistance.
Losses are divided and liabilities spread according to the community pooling system.
Uncertainty is eliminated in respect of subscription and compensation.
It does not seek to derive advantage at the cost of others.
In theory, Takaful is perceived as cooperative insurance, where members contribute a certain sum of money to a common pool. The purpose of this system is not profits but to uphold the principle of "bear ye one another's burden."


Status of Takaful:
As Islamic finance continues to expand, there is likely to be a huge takeoff of other products such as pensions, education, marriage and health Takaful plans. There is also a huge scope for mortgage Takaful.

Islamic principles strong emphasis in Takaful on the economic, ethical, moral and social dimensions, to enhance equality and fairness for the good of society as a whole should also have appeal for the ethically minded.
In modern society, insurance has become a necessity to trade and industry. Life insurance has become the most effective vehicle for mobilising savings, for capital formation and for long-term investment, as well as for making provision for old age and bereavement in the case of individuals.
In the west, the insurance sector is the largest single contributor to the capital market. Banks and insurance companies now form international alliances for mutual benefit.
There is an increasing demand for a Shari'ah-compliant insurance system. Until recently, there has been a low demand for insurance in Islamic countries, because Muslims believe that insurance is un-Islamic. The development of Islamic insurance, therefore, requires extensive education of the Muslim public, besides development of resources and expertise, a legal framework for it, the harmonization of practices, development of new Shari'ah-compliant instruments, accounting standards, and arrangements for retakaful.

How does Takaful Work?

All participants (policyholders) agree to guarantee each other and, instead of paying premiums, they make contributions to a mutual fund, or pool. The pool of collected contributions creates the Takaful fund.

The amount of contribution that each participant makes is based on the type of cover they require, and on their personal circumstances. As in conventional insurance, the policy (Takaful Contract) specifies the nature of the risk and period of cover.

The Takaful fund is managed and administered on behalf of the participants by a Takaful Operator who charges an agreed fee to cover costs. These costs include the costs of sales and marketing, underwriting, and claims management.

Any claims made by participants are paid out of the Takaful fund and any remaining surpluses, after making provisions for likely cost of future claims and other reserves, belong to the participants in the fund, and not the Takaful Operator, and may be distributed to the participants in the form of cash dividends or distributions, alternatively in reduction in future contributions

Operating Principles:
An Islamic insurance company must have the following operating principles:
a) It must operate according to Islamic co-operative principles.
b) Reinsurance commission may be paid to, or received from, only Islamic insurance and reinsurance companies.
c) The insurance company must maintain two funds: a participants/policyholders' fund and a shareholders' fund.
The Policyholders' Fund:
a) The assets of the policyholders' fund consist of:
Insurance premiums received
Claims received from re-insurers
Such proportion of the investment profits attributable to policyholders as may be allocated to them by the Board of Directors.
Salvages and recoveries
Consultancy and other receipts.
b) All the claims payable to the policyholders, reinsurance costs, technical reserves, administrative expenses, etc., excluding the expenses of the investment department, shall be met out of the policyholders' fund.
c) The balance standing to the credit of the policyholders' fund at the end of the year represents their surplus. The General Assembly may allocate the whole or part of the surplus to the policyholders' special reserves. If a part, the balance will be distributed among the policyholders.
d) When the policyholders' funds are insufficient to meet their expenses, the deficit is funded from the shareholders' fund.
e) The shareholders undertake to discharge all the contractual liabilities of the policyholders' fund, but this liability does not exceed their equity in the company.
The Shareholders' Fund
a) The assets of the shareholders' fund consist of:
Paid-up capital and reserves attributable to shareholders
Profit on the investment of capital and shareholders' reserves
Such proportion of the investment profit generated by the investment of the policyholders' fund and technical and other reserves as is attributable to them
Miscellaneous receipts
b) All the administrative expenses of the investment department are deducted from the Shareholders' Fund.
c) The balance of the shareholders' surplus, if any, is distributed among them.
Investment of Funds:
The company may invest its funds only on a profit-and-loss-sharing basis, as approved by the Shariah.
Products and Services Offered by Islamic Insurance Companies
Islamic insurance companies may offer competitively priced products, without curtailing the scope and benefit of insurance coverage made traditionally available to the public by conventional insurance companies.
As regards life insurance facilities, Islamic insurance companies have developed Islamic Trust Funds for social solidarity, mortgage protection, student protection and employers' protection.
Models of Takaful:
There are various models of takaful according to the nature of the relationship between the company and the participants. There are wakalah (agency), mudarabah and a combination of the two. In the Sudanese takaful model, every policyholder is a shareholder in it. An Operator runs the business on behalf of the participants and no separate entity manages the business. Shari'ah experts consider this preferable. In other Islamic countries, the legal framework does not allow this arrangement and takaful companies work as separate entities on the basis of mudarabah (in Malaysia) and wakalah (in the Middle East).
In the mudarabah model practised mainly in the Asia Pacific region, the policyholders receive any available profit on their part of the funds only. The Shari'ah committee of a takaful company approves the sharing ratio for each year in advance, most of the expenses being charged to the shareholders.
In the wakalah model, the surplus of policyholders' investments – net of the management fee or expenses - goes to the policyholders. The shareholders charge the wakalah fee from contributions and this covers most of the expenses of the business. The fee is fixed annually in advance in consultation with the company's Shari'ah Supervisory Board. The management fee is related to performance.

Differences between Takaful and Conventional Insurance
The overwhelming majority of Islamic jurists have concluded that the conventional insurance contract is unacceptable to Islam, not being in conformity with the Shariah for the following main reasons:
a) it includes an element of al-gharar (uncertainty)
b) it is based on the theory and practice of interest; a conventional life insurance policy is based on interest, while an Islamic model is based on tabarru where a part of the contributions by participants are treated as donation. For this reason, policyholders in takaful are usually referred to as participants.
c) It is a form of gambling.
First and foremost, Islamic insurance, in conformance with the Islamic Shari'ah, is a form of social solidarity (takaful), based on the principles of trusteeship and co-operation.
1) In conventional insurance, the insured substitutes certainty for uncertainty. In return for a predetermined payment, the premium, he/she transfers to the insurer the possible economic losses from stipulated risks. In Islamic insurance, the participants share all risks mutually and no transfer of risk is involved.
2) Conventional insurance companies are motivated by the desire for profit, while Islamic insurance companies are non-profit making, the shareholders not being entitled to share in the profits of the business although they are entitled to charge fees for their services and share in the investment returns of funds managed by them
3) The policy-holders in a conventional insurance company have no right to vote in the elections of the directors of the company or to see the annual accounts of the company, while in Islamic companies; these facilities are available to all participants who pay a certain stipulated amount of premiums (contributions
4) In the takaful system, if the assured dies before the policy matures, the beneficiary is entitled to the whole amount of the premiums, the bonus and dividend and a share of the profits made over the paid premiums, plus a donation from the company out of the participants/policy-holder's contributions given on the basis of tabarru. Such a transaction is seen as a mutual contribution towards the welfare of the helpless in society. Where the insured is still alive on the maturing of the policy, he/she is entitled to the whole amount of the premiums, a share of the profit made over the premiums, a bonus and dividends according to the company policy.
5) In a conventional life insurance policy, the agent's payments are paid out of the insured's paid premiums, whereas in the Islamic model, the agents work for the company and thus are paid by the company.
6) The insurable interest in the conventional system is usually paid to the policyholder, if he/she is alive at the expiry of the policy. If he/she dies before that date, the insurable interest is paid to the beneficiaries, who may include including family, servants, company, trustee, partners, mortgagor, etc. But under the Islamic model, the insurable interest goes to the assured or his/her heirs, according to the principles of Mirth or Wasiyyah.
Co-operative Insurance
The concept of co-operative insurance is acceptable in Islam because:
a) The policyholders co-operate actively for their common good;
b) Every policyholder pays his subscription in order to help those who need it;
c) It spreads liability in the community by a pooling system;
d) It does not aim at deriving undue advantage for one at the cost of other individuals;
e) The element of uncertainty is eliminated as far as determination of the premiums is
concerned.
An Islamic co-operative insurance contract should embody the following conditions:
a) The company functions according to Islamic co-operative principles.
b) The policyholders have the right to participate in surplus profits and are liable to contribute additional amounts if their subscriptions are not sufficient to meet all the losses. However, it is preferable for such losses to be written off against future surpluses. Shareholders are not entitled to any of the underwriting profits generated by the insurance operations. But, as mudarib (agents), they are entitled to receive a proportion of the profits from the investment of insurance funds, plus, of course, all the profits on the investment of their own capital and any other funds and reserves attributable to them.
c) The company will strictly follow Islamic laws in the matter of investment and will not indulge
in the practice of usury.
d) Policyholders are represented on the Board of Directors and have a right to scrutinise its
accounts.