Takaful – An Islamic Alternative to Insurance

There was no direct equivalent of insurance in classical Islamic traditions. Since Insurance is about risk mitigation, the scholars had to look for equivalent strategies in the early periods. The word Takaful is derived from the Arabic word “Kafalah” which translates to taking care of someone’s needs. The members of a group contribute to a fund which can be used by another member in case of need.

An equivalent of Takaful had existed in the time of the Prophet (PBUH) in the form of Aaqilah, where the members of a tribe paid into a fund to help a person of their tribe pay diyah (blood money). Islam endorsed the concept of Diyah in Quran Chapter 4 Verse 91 with further guidelines. Diyah is to be paid to the survivors of a murder victim as compensation by a group of people or the community. However, the victim’s relatives have to be in agreement with the payment. The responsibility of payment was shared by the tribe thus spreading the risk among several individuals.

Another equivalent of Takaful is found in Kafalah or Daman (guarantee) issued by one party to guarantee the performance of another party. Makkah was a town of caravan traders and they collected funds to safeguards themselves against natural disasters or hazards of the caravan journeys. Another example of origin of Takaful is Ju’alah where an entity issues a reward or wage for a certain task considering that the outcome is uncertain.

During early Islamic centuries the need for risk mitigation was realized as Muslim traders spanned the known world. This was done though collection of funds to compensate a trader who might have suffered unexpected losses during a journey. However, this system of mutual cooperation was never formalized until the rise of the Western European powers and the development of modern insurance schemes. At first, Islamic scholars were expectedly opposed to it as an imported idea which had no basis in Islam. Towards the last quarter of twentieth century, the developments in Islamic finance gave rise to the concept of Takaful as an alternative to conventional insurance. Insurance is a necessary tool for the modern economy.

The primary of objective of Takaful is risk mitigation. In conventional insurance the risk is assumed by the insurer. In contrast, Takaful is based on sharing the risk among its participants. The members of a Takaful scheme jointly protect themselves against a catastrophic event resulting in a loss to any member. A Takaful life insurance does not insure anyone’s life but rather provides assistance to survivors in case of an untimely death. The Kafalah (guarantee or surety-ship) under Takaful provides a cover of protection to the participant on the basis of mutual cooperation. Humanity has moved on from the early days when people lived in small groups and everyone in the group was protected.

More specific objectives of Takaful are to support community cohesion, protect the community against adverse events, improve the quality of life by providing some financial security, and provide opportunity to earn profits for members based on investment of the collected funds.

The following are key differences between Takaful and conventional insurance:

1. Riba: Riba or interest is almost always present in the conventional insurance. There is direct Riba in the form of difference between premium collected and insured sum paid. Interest is also earned on the collected premiums as they are usually invested in interest based securities. Takaful does not involve Riba.

1. Risk: In conventional insurance the insured transfers his or her risk to the insurer. The insured pays a certain premium in return for a guaranteed payment in case of loss. The insurer uses actuarial methods to determine the premiums which will collectively result in profits for the insurer. A Takaful scheme is based on sharing of risk between its participants. The participants collectively own the funds and pay out to those who need. Takaful operator only acts as a trustee to manage the insurance scheme and the funds. The participants also share any surplus funds if all the collection has not been used up. Any losses are covered first by contingency reserves, then from stock holders’ equity as a Qard Hasan, and lastly by an increase in the pricing of premiums.

• Profit Motive: Conventional insurance companies are “for profit” companies whose main goal is to generate as much profit as possible for their shareholders. This results in exploitation of certain class of people. Takaful operators follow Shari’ah guidelines which mandate fairness for both participants and operators. The profit motive is present but only through ethical means which benefit the society without exploitation. Some Takaful operators are set up as non-profits also where the premiums and investment earnings cover the business expenses and the capital is used for business development.

• Exploitation: There is always a possibility of exploitation in commercial insurance through charging of high premiums and increasing profits for the company. Takaful is based on profit sharing so there is less chance of exploitation. If the total amount of premiums is higher than payments for losses, the excess is given back to the participants in the form of rebates or discounts.

• Shari’ah Supervision: Conventional insurance companies are usually regulated by a country’s regulatory body. Takaful operators are subject to similar regulation but they also have additional requirements of supervision by Shari’ah Supervisory Boards. This provides additional protection for the consumer. This also guarantees that investments of the company will be in Halal businesses only. Any distribution of profits is also based on Shari’ah principles.

• Gharar and Maysir: Conventional insurance contracts involve Gharar (undue uncertainty) and Maysir (gambling) which are prohibited in Shari’ah. The insured does not know if he will receive any financial benefits from his premiums and the insured has no knowledge of the nature of the claims. Similarly, the insured and the insurer are both gambling to see who benefits the most financially out of the contract. The cooperative nature of Takaful and Shari’ah compliance remove or minimize these elements to assure that the insurance is actually used as a risk mitigation tool only for the benefit of the community.