How Takaful (Islamic Insurance) Works: Understanding the Concept of Takaful

In this blog, we delve into the fascinating world of Takaful, the Islamic insurance model that is based on mutual cooperation and risk sharing. We've taken the complex concepts outlined in Dr. Mohd Daud Bakar's seminal work "Shari’ah Principles Governing Takaful Models" and distilled them into a more digestible form for our readers. By simplifying and summarizing Dr. Bakar's work, our aim is to provide a comprehensive understanding of Takaful and its underlying principles for those seeking to learn more about this unique form of insurance.

Exploring the Mutual World of Takaful: An In-Depth Look at Islamic Insurance Principles

Takaful (Islamic Insurance) is a type of insurance that is based on the principle of mutual protection and support. Unlike conventional insurance, a commercial transaction between the insurance company and the policyholder, takaful operates on the idea of members helping each other. In other words, the takaful participants (or members) collectively contribute money to a pool, and any member who experiences a covered loss is reimbursed from the pool. The takaful operator is not an insurance company but rather manages the operations, such as underwriting and claims processing, on behalf of the members. Takaful is different from conventional insurance in several ways. For example, it is guided by a set of principles that are both in accordance with Islamic law (Shari'ah compliant) and economically viable. Additionally, takaful requires high standards of corporate governance and risk management, similar to the best practices in the insurance industry. This means that takaful is a new way of providing protection and indemnity that is both ethical and practical.

Understanding Takaful (Islamic Insurance) and the Differences between Conventional Insurance and Takaful

Takaful (Islamic Insurance) is a concept of insurance that is based on Islamic principles. It involves a group of people who contribute to a common fund in order to provide indemnity (compensation) to one another in the case of a specified event.

This is different from conventional insurance, where the insurance company provides indemnity in exchange for a premium paid by the policyholder. The obligation to pay the claims in takaful lies with the takaful fund, which is made up of contributions from all the participants. Takaful operates on a different business model than conventional insurance. Instead of transferring risk to the insurance company, takaful involves risk sharing among the participants. The takaful operator may be obligated to ensure the solvency of the takaful fund, but the obligation to pay claims is with the fund itself. The takaful operator may receive income from various sources, such as wakalah fees and profit sharing from investments.

In short, takaful (Islamic Insurance) is a unique concept of insurance that is based on mutual cooperation and risk sharing among participants, rather than risk transfer to an insurance company.

The Legal Aspects of Takaful Contracts: Tabarru' and its Role in Takaful

A contract for Takaful (Islamic Insurance) is a crucial element in Islamic finance as all financial dealings between people must be based on a contract that complies with the principles of Shari'ah. The contract must not involve any elements of riba (interest) or gharar (uncertainty). In the context of Takaful, the contract outlines the contributions made by participants, the investment of these contributions, and the payment of claims to the entitled parties. In comparison, the concept of insurance is more straightforward from a commercial perspective. It is simply a contract between the policyholder and the insurance company where the policyholder pays a premium, and the insurance company provides the sum insured or pays a claim. However, the concept of insurance cannot be adopted for Takaful because uncertainties are inherent in both the premium and claim, which goes against the principles of Islamic law. As a result, the first global fatwa for Islamic insurance required the Takaful contract to be based on a tabarru' or donation contract.

Tabarru’ refers to a type of contract in Islamic commercial law where a person voluntarily gives away their property or right to another party without receiving any consideration in return. The requirement of certainty of both the subject and consideration is not relevant in this type of contract as it is based on the donor's goodwill or favour. Issues such as uncertainty, mistake, fraud, or misrepresentation are not relevant in a tabarru’ contract as it is not intended for commercial purposes.

However, when it comes to takaful, a type of Islamic insurance, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has a more technical view of tabarru’. Takaful is defined as a collective undertaking by the participants to donate, rather than just an individual donation contract. This makes the takaful contract more structured and legalistic. However, the question arises whether a participant can impose a condition that they will only donate if they can potentially benefit from the takaful fund in the case of a loss or damage. This is known as a conditional gift for a consideration. Some Islamic commercial law texts indicate that a gift with a condition of consideration is compliant with Shari’ah principles. Therefore, it is permissible for someone to donate with the expectation of benefiting from their donation in the future.

The Central Tenet of Islamic Insurance: Risk Sharing vs Risk Transfer in Takaful

The principle of risk sharing, as opposed to risk transfer, is a central tenet of Islamic insurance. This is because Islamic jurisprudence prohibits transferring risk for a fee, and instead advocates for the sharing and distribution of risk among a group of people.

In traditional insurance, a policyholder pays a premium to transfer their risk to the insurance company. However, in Islamic insurance, the risk is not transferred for a fee but rather is shared among the participants through a process of mutual donation. Each participant in the group agrees to absorb a portion of the risk of the group and the financial burden, according to a previously agreed formula.

The principle of risk sharing has a historical precedent, dating back to the second Caliph, Umar al-Khattab, who introduced this concept through his institution of Dawawin. Each section of the government agencies he created was required to contribute money for the mutual benefit of the section.

In modern Islamic insurance and takaful, the contribution or premium must reflect the risk profile of the insured, just as in traditional insurance. The principle of risk sharing is in line with the views of Shari'ah scholars.

Ownership of Takaful Fund

The takaful fund is a separate fund that is not owned by the takaful operator (TO) or its shareholders. Instead, it is owned by the participants who have made financial contributions to the fund. The TO manages the fund, but it does not have ownership rights over it. The TO is entitled to fees or profit shares from the fund, depending on the management contract between the takaful participants and the TO.

In general takaful, the contributions made by the participants are seen as donations. Each individual contribution is considered a gift with no expectation of receiving anything in return. However, collectively, the participants own the takaful fund and have individual rights to it based on the terms and conditions of their takaful policy.

In family takaful, the contributions are viewed more as an investment than a donation. A portion of the contributions goes toward risk protection, while the remaining amount is managed as an investment to generate returns for the participants. The ownership of the investment funds remains with the individual participants, not with a third party.

The ownership rights of the takaful fund have never been transferred to the TO, so in the event of liquidation, the creditors of the TO do not have the right to access the assets of the takaful fund. The underwriting surplus, if not retained for solvency purposes, should be distributed among the participants. However, the participants may agree with the takaful policy to share some of the underwriting surpluses with a charitable organization.

One important issue regarding the ownership rights of the takaful fund is the extent to which it is protected in the event of the liquidation of the TO. It is proposed that the takaful fund be registered as a trust fund, with a legal personality of its own and managed by the TO as trustee. The participants would be the sole beneficiaries of the fund, and a trust fund is not affected by the bankruptcy of the trustee. This would provide more legal protection for the takaful fund.

The Deficit in a Takaful Fund: The role of Qard

In the case of a takaful fund running into a deficit, it means that the claims of the participants have exceeded their contributions and reserves. This could lead to immediate insolvency of the takaful fund and inability to pay out claims. To prevent this, the takaful operator (TO) may provide a qard hasan or an interest-free loan, which will be recovered from future contributions. The obligation of the TO to provide this loan may vary depending on the jurisdiction, with some regulators requiring it, while others having it included in the Articles of Association of the TO. The provision of this loan helps to secure the payment of claims in case the takaful fund runs into a deficit.

However, there are some important considerations to be taken into account when providing this loan. Firstly, the loan should not reduce the TO's capitalization as the funds still belong to the TO and should not have any effect on the TO's regulatory capital. Secondly, the investment returns from the loan should be for the benefit of the shareholders alone, and lastly, the provision of this loan must be compliant with Shari'ah principles to ensure that it aligns with Islamic insurance principles.

In simple terms, the disclosure of the capital for a qard hasan facility at the beginning of its operation can have an important effect on the ratings assigned to it. This capital is set aside to support the takaful fund if necessary. According to Islamic law, once the facility is used, the borrower (the takaful fund) is entitled to any returns from the funds used. However, this may not be beneficial to the provider of the loan.

The qard facility must be repaid out of future contributions, and Islamic law prohibits any additional benefit to the lender. This means that charging a management fee based on contributions set aside for repayment of the loan may not be allowed.

Despite this, the provision of a qard hasan facility can still serve the ratings and capitalization purposes of a takaful scheme. To make this practice compliant with Islamic law and meet the requirements of ratings and capitalization, it is proposed that a reserve account under a trust concept be used. The trustee would manage a trust account with a certain amount of money and invest it for their own benefit, but the income from these investments would be returned to the reserve account. This trust account would only be used in case of a deficit in the takaful fund and the trust deed would clearly state that the account is irrevocable and the beneficiary is the takaful fund. The trust account would also meet the capitalization requirements by serving as the capital for the provider of the loan.

Takaful Models: Wakalah, Mudarabah, and Combined Approach

Takaful is a form of Islamic insurance, which operates on mutual assistance principles. The management of takaful funds can be divided into three models: wakalah, mudarabah, and a combination of wakalah and mudarabah.

In the wakalah model, participants appoint the takaful operator (TO) as their agent or manager to manage the activities of the takaful fund. The TO is entitled to receive a fee for this service, which is determined upfront and paid from the contributions. The profits and risks arising from the management of the takaful fund belong to the participants.

In the mudarabah model, participants appoint the TO as the investment manager of the takaful fund. The TO may share in the returns from the investment of the takaful fund, but only if there is a return generated. If not, the TO is not entitled to receive any compensation for its services.

In the wakalah-mudarabah model, the TO provides services related to day-to-day takaful operations under the wakalah contract and invests the takaful fund and shares in the returns under the mudarabah contract. The TO is entitled to receive fees under the wakalah contract and a share of the investment returns if any.

It is important to observe the legal effects arising from the management model chosen by the TO. For example, a general takaful operator who adopts the mudarabah model is not allowed to share in the underwriting surplus because it is not considered as a profit under a mudarabah contract. The TO may either change the model to a wakalah model or a combination of wakalah and mudarabah to earn some income.

So what did we learn?

To conclude, Takaful (Islamic Insurance) is a unique form of insurance based on the principle of mutual cooperation and risk sharing. It operates differently than conventional insurance, as it requires a Shari'ah-compliant contract and prohibits elements of riba (interest) and gharar (uncertainty). The takaful contract outlines contributions made by participants, investment of these contributions, and payment of claims. The principle of risk sharing is at the core of takaful, where participants collectively absorb the risk of the group instead of transferring it to an insurance company. The principle of risk sharing dates back to the second Caliph, Umar al-Khattab, who introduced the concept of mutual benefit through his institution of Dawawin. Takaful operates with high standards of corporate governance and risk management, making it an ethical and practical form of providing protection and indemnity.

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