Islamic Banking and Finance Research Paper of 13 pages

Introduction to Islamic Banking and Finance:
Principles and Practice

M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni

Chapter 8
Islamic Insurance (Takaful)

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Learning Objectives

Upon the completion of the chapter, the reader should be able to:

Understand the meaning and basic concepts of takaful as an alternative to conventional insurance with an insight into its historical development

Describe the innovative Sharī‘ah-approved models and structures of takaful

Describe the main takaful products and their expansion into the global insurance market

Analyze the process of determining and allocating surplus or deficit as proposed by AAOIFI

Explain the relevance of reinsurance and retakaful in the modern practice of takaful business

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Basic Concepts of Takaful

• Takaful - Arabic word originating from the root verb kafalah –to guarantee, to secure or to be responsible for others
• Literally, takaful means joint responsibility or guarantee based on mutual agreement
• Three basic concepts of mutuality are embodied in the takaful model of insurance:

- Mutual help

- Mutual responsibility

- Mutual protection

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Basic Concepts of Takaful

Figure 8.1: Triangular Relationship of the Major Aspects of Takaful

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Basic Concepts of Takaful

• Takaful: Islamic alternative to conventional insurance where members contribute financial resources into a pool based on principles of:

- ta’awun (mutual assistance)

- tabarru’ (donation)

to share the mutual risks together

• A Sharī‘ah-compliant framework to effectively manage risks in commercial activities as well as other civil engagements - following the hadith ‘Tie your camel first’
• All prohibitive elements in Islamic commercial transactions are prohibited in the design of takaful models

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Basic Concepts of Takaful

Main Features of Takaful

1. Cooperative Risk Sharing

2. Clear Financial Segregation

3. Sharī‘ah-compliant Policies and Strategies

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Basic Concepts of Takaful

Main Features of Takaful

1. Cooperative Risk Sharing

• Cooperative risk sharing through the use of donation was designed to:

- eliminate riba and ghrar elements in takaful
- address issues of social responsibility, solidarity and the innate need to care for others

• Donations adopted/merged with other frameworks of Islamic commercial transactions to replace premiums
• Premiums paid by policyholders are considered donations to assist members who suffer any loss

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Basic Concepts of Takaful

Main Features of Takaful

2. Clear Financial Segregation

• In Islamic law:
• Clear segregation between participants and operators
• The role of the insurance company is restricted to an operator managing the portfolio and investing insurance contribution on behalf of participants
• In the conventional insurance business:

The insurance company is a profit-making entity which agrees to bear the financial burden and losses of its policyholders

• The shareholders are entitled to receive profit and bear the burden of any deficit at the end of the financial year

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Basic Concepts of Takaful

Main Features of Takaful

3. Sharī‘ah-compliant Policies and Strategies

• Investment of insurance funds should be made on ethical businesses causing no harm to people or environment

• Ethical considerations extends to investments in businesses /products that do not contradict Sharī‘ah. Both the process and end-product must be Sharī‘ah-compliant
• Takaful operators are required to have a standard Sharī‘ah governance system to ensure absolute compliance with the Sharī‘ah

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Basic Concepts of Takaful

Takaful Core Principles

• Ta’awun (mutual assistance)

• Tabarru’ (donation)

• Prohibition of riba, gharar and maysir

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Basic Concepts of Takaful

Major Differences Between Takaful and Conventional Insurance

The major differences between the two frameworks are:

• Parties to the contract
• Payment of premiums
• Investment of insurance funds

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Specific Differences between Takaful and Conventional Insurance

Table 8.1

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Basic Concepts of Takaful

Historical Development of Takaful

• The Prophet (PBUH) upheld and preserved insurance protection practices carried out by ancient Arab traders.

• A classical precedent of takaful among the Muslims was displayed after the migration of the Prophet to Medina

• The companions promoted mutual assistance and shared responsibility under the Prophet leadership.

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Basic Concepts of Takaful

Figure 8.2: Timeline of the Development of Takaful

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Basic Concepts of Takaful

• The modern history of takaful

Islamic Insurance Co. established in Sudan in 1979

The establishment of Islamic-Arab Insurance Company in Saudi Arabia and later in UAE in 1980

The Malaysian Takaful Act of 1984

• Contemporary Islamic Scholars Resolutions

Many resolutions on the permissibility of takaful

Resolution of the Council of Saudi Scholars in 1977

The resolutions of the Fiqh Council of the Muslim World League in 1978

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Basic Concepts of Takaful

• The OIC Fiqh Academy approved the takaful system in 1985
• The growth in the takaful industry is estimated at 10-20 percent a year

• The global takaful market reached US$ 19 Billion in 2017. The market is further projected to exceed US$ 40 Billion by 2023, at a CAGR of 13% during 2017-2023.

Source: https://www.prnewswire.com/news-releases/global-takaful-market-2017-2018--2023-300709652.html

For more recent data, visit: World Takaful Report - Ernst & Young www.ey.com/.../World_Takaful_report...2011/.../WTR2011EYFINA

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Models of Takaful

The main two parties the takaful system regardless of the takaful model being used are:

• Takaful operator: the party who manages and administer the takaful fund
• Participants: the owners of the takaful fund, participants and policyholders

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Models of Takaful

• The Mudarabah Model

• The Wakalah Model

• Hybrid Wakalah-cum-Mudarabah Model

• Wakalah with Waqf Model

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Models of Takaful

The Mudarabah Model

• It is based on trust partnership between the takaful operator (mudarib) appointed to manage the takaful business by the participants who act as the financiers or fund contributors (rabb al-mal)

• The funds contributed by the participants are divided into:

- Participants’ Risk Fund (PRF) or and - Participants’ Investment Fund (PIF)

• The Takaful Participants are the capital providers and the owners of the takaful undertaking

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Models of Takaful

The Mudarabah model

• The Takaful Operator is considered a business partner of the participants in the investor-entrepreneur relationship under the mudarabah contract
• The ratios of profit distribution are predetermined
• Financial loss is borne by capital providers (Participants), while the entrepreneur (Operator) may lose his/her managerial efforts
• Takaful Operator remunerated from the underwriting surplus as agreed in the underlying takaful contract

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Models of Takaful

Surplus

The amount that remains after all expenses and management fees for the administration of the takaful fund have been deducted and the contributions are more than the claims made by the participants

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Models of Takaful

Figure 8.3 An Example of the Mudarabah Model of Takaful

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Models of Takaful

The Wakalah Model

It is based on the contract of agency between the takaful participants and the takaful operator where:

- the takaful participants are the owners of the fund - the takaful operator acts as an agent

The takaful operator is entitled to agency fee or commission for its service. The agency fee must be specified and clearly stated in the contract

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Models of Takaful

• IFSB-8 suggests that the agency fee should cover the total sum of the following costs:

- management expenses; - distribution costs, including intermediaries’ remuneration; - a margin of profit to Takaful Operator

• Any surplus from the investment of the participants’ funds will go to the participants.
• The operator only receives its agency fee based on the nature of the takfaul model.

• The Takaful Operator does not share in any risk in the investment or management of the takaful fund.

The Wakalah Model

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Models of Takaful

Figure 8.4: Example of the Wakalah Model of Takaful

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The Wakalah Model

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Main Takaful Products

Hybrid Wakalah-Mudarabah Model

• The hybrid takaful model (also called the mixed model) is a combination of wakalah & mudarabah models where:

the wakalah model is used for the underwriting purposes

the mudarabah model is used for the investments

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Models of Takaful

Hybrid Wakalah-Mudarabah Model

Twin role of the takaful operator makes the model unique :

Takaful operator is entitled to agency fee or predetermined commission for the a wakil or agent role

- Takaful operator is also entitled to a share in the profits realised for managing the investment activities as an entrepreneur (mudarib)

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Models of Takaful

Hybrid Wakalah-Mudarabah Model

• The sources of income of the takaful operator consist of:

- Agency fee

- Iincentive fee

- Profit share from the investment of the funds

• One important element of the hybrid model is the clear segregation between the shareholders’ funds and the participants’ funds

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Models of Takaful

Figure 8.5: Hybrid Takaful Model

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Hybrid Wakalah-Mudarabah Model

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Models of Takaful

Waqf-Wakalah-Mudarabah Model

The Waqf Component

• Shareholders of a takaful company make donations to a common pool of funds, established as a waqf.
• Waqf funds are invested in Sharī‘ah-compliant activities.
• Returns from such investments in addition to tabarru’ funds in Participants’ Special Account (PSA) are used for the benefit of the participants.
• The original capital amount contributed into the common pool must be reinvested to ensure continuity of waqf funds

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Models of Takaful

Waqf-Wakalah-Mudarabah Model

The Wakalah Component

• Shareholders of the Takaful company donate to common pool, establishing a waqf fund
• The company becomes the agent of the shareholders and assumes responsibilities of proper management of the waqf funds, paying necessary claims
• Company receives a pre-agreed fee for acting as an agent of the shareholders
• The company also manages the investment of such waqf funds as an entrepreneur, therefore entitled to share in the profit from investment

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Models of Takaful

Figure 8.6: Model (Ultra-hybrid Model)