Insurance is a means to financially protect and safeguard your assets, your wealth, and even your life. Sometimes getting insurance is a requirement by law. Other times it’s a means of shifting risk onto another party, for a fee. There are many insurance services readily available today, including car insurance, travel insurance, life and medical insurance.
According to Shariah principles however, the conventional insurance model is not permissible. This is with the exception of legally required insurance products like motor insurance where an alternative may not exist, as many scholars agree this is out of necessity.
But for what reason does Islam forbid conventional insurance, and does it offer any alternative, and if so, how does it achieve this?
Why can’t Muslims get conventional insurance?
There are three key objections to conventional insurance that are often blurred together. These are:
Gharar (Excessive Uncertainty) - An insurance contract is built upon severe degrees of uncertainty. You may be paying insurance premiums for years and years without making a single claim. Alternatively you may claim far more than the amount you have paid. Actuaries may try to predict the likelihood of these events occurring to more accurately price these, but in reality, many of these events have no guarantee of occurring, and the insurance companies are banking on this.
Maysir (Speculation/Gambling) - Similarly, but distinct to the above point, insurance can be a speculative exercise whereby you are essentially placing a small wager on a predicted outcome of a large payout. This is essentially gambling which is forbidden in the confines of Islam. I have talked more on this in my previous articles (e.g. Aqila Finance).
Riba (Interest) - This is more indirectly linked, but insurance premiums are often pooled and invested into interest bearing assets and thus, there is interest involved in the pool of money that is used to pay out claims.
It should be noted Gharar and Maysir are objections to the contract structure (risk-transfer for a price), while riba is an objection to the investment of the pool. The Islamic Insurance model (Takaful) aims to fix the first pair structurally and the third through compliant asset management.
Takaful - how does it work?
The Islamic answer to insurance is to emphasise risk-sharing rather than risk-transfer. Participants here contribute to a common pool via tabarru’ (donations). This pool amongst the participants is what pays the claims. A third party operator of this pool manages it for a fee, rather than actually taking on the risk from you. This works much like a conventional mutual insurance structure rather than the standard shareholder-owned insurance firm (what most refer to when talking about insurance).
How does Takaful differ from conventional mutual insurance?
Conventional mutual insurance intends for policyholders to be both the owners and the insured. The issue with this however is that these have been seen to shift closer to the standard shareholder owned model and ‘demutualise’. This shift has become prominent due to the need to become public, shareholder owned companies, to be able to tap into larger sums of capital to both meet regulatory requirements (sufficient liquidity reserves), but also to benefit from the economies of scale and remain competitive.
Takaful and conventional mutuals also differ in legality (adhere to Islamic jurisprudence) and structure. Although there may not be as heavy a speculative profit-seeking issue here (Maysir) as ownership and insured roles overlap, Gharar still occurs in these transactions as there is still a significant degree of uncertainty whether the event will occur or not.
To overcome this, the contract has to be based on tabarru’ (donations). The policyholders provide funds with the intent of donating money to a pool of resources that can help the wider community (including themselves). This is seen as less of an individualistic transaction where you are simply covering yourself, but rather you are supplementing a community fund that covers each relevant member.
There is however a point of contention here as Gharar still does technically exist. It is not seen as impermissible in this instance however, as this is not seen as a contract of exchange but is rather donation funded. The difference here however is intention, but the intent to donate is not an easily provable motive for insurance, so the criticism here is this simply being a legal fiction. A recurring message I have replayed, however, is that Islam is a practical religion, and the structure is still set up in a way that is widely accepted by Islamic scholars, as no other alternative that follows Islamic principles this closely, exists.
On the point of Riba, unlike conventional mutuals, the pooled insurance funds cannot be used towards income-generating assets that are associated with Riba (interest) or any other impermissible economic activity for that matter.
Takaful Operating Models
Takaful generally functions on a two-tier structure. The first tier being the operator, a limited company that has shareholders. Their function is to essentially be an asset manager of the funds and invest the money accordingly for a fee. The second tier is the policyholders pooled funds which are ring-fenced from the shareholders’ money of the operator. The operator also does not share in any of the risk of the downside relevant to these assets, they are simply the money managers. Any deficits in the fund are funded either via, a permissible financing agreement (i.e. no interest involved), Qard Hasan - an interest free loan from a third party (including the Takaful operator who can be refunded via future profits) or by the policyholders injecting more cash into the pool, if agreed at the outset of the contract. The Takaful operator being able to backstop deficits, however, raises the argument that risk-sharing has morphed into risk-transfer with extra steps, so there is criticism in this regard.
The mechanisms behind this two-tier structure broadly follows one of the following three frameworks;
Wakala (Agency) - the Takaful operator acts as an agent on the policyholders’ behalf and takes a fixed fee to manage the fund, with the underwriting surplus staying with participants.
Mudaraba (Profit-sharing) - The operator shares in the underwriting surplus with a pre-agreed profit ratio split. As mentioned before, they do not share in the losses. They are still at risk that they won’t obtain any profit from the venture however.
Hybrid (Wakala & Mudaraba) - a combination which includes a fee on the contributions and then a profit-share on investment returns. This is the most common approach taken.
The existence of a hybrid structure exists due to the fact that firstly in a Wakala agreement, a fixed fee gives the operator no incentive to invest the pool well at all. In the Mudaraba model alone the operator is at more of a risk that they won’t get a return for their services, and in turn their motivations start to misalign with those of the policyholders as they have incentives to generate significant investment returns to secure higher profits, which is not the purpose of the insurance pot. Profiting of an amount that is donated to a mutual pot is also a controversial outcome seen in the Mudaraba model. AAOIFI (The Accounting and Audit Organisation for Islamic Finance Institutions), encourages and leans towards the Wakala model for this reason.
The expected value of Takaful surplus should be zero as funding and drawdowns should average out the pot over time (except with the case of intentionally building up reserves). The surplus for policyholders is to be able to eventually cover future drawdowns or deficits. Having a hybrid element therefore helps realign the operators’ motivations to still seek investment profits but not to obtain excessive underwriting surpluses, which is separated and kept with participants.
Types of Takaful
Family Takaful
The purpose of Family Takaful is similar to conventional life insurance, to pay out death benefits when an individual dies before the policy hits maturity. For Family Takaful there is more emphasis on long-term investment performance, to help pay out to the policyholder’s family, especially if that individual is the main source of income for the household. Here the premiums are split based on what goes to the shared insurance fund (this differs based on the individuals’ characteristics that an actuary uses to determine the associated risks, and therefore the relevant premium they should pay), and the investment fund, for long-term growth and wealth generation for the family.
General Takaful
General Takaful covers most other events and can relate to both short and long-term risks associated with these. They however mostly relate to short term cover like motor or property insurance. Here there is greater emphasis on obtaining a larger risk pool to rely on the law of large numbers to help smooth out the surplus and deficits.
Retakaful
In conventional insurance, reinsurers can be engaged to further reduce the risk exposure, by insurance providers paying a portion of the premium received to cover a proportion of their risk. A similar parallel is seen in Retakaful, however this is a very small market but it is important given that Takaful providers operate within an immature market themselves. Because of this there is leeway given by some scholars that allow Takaful providers to reinsure with conventional reinsurers out of necessity, but this is still seen as a controversial outcome by most scholars.
The Reality of Takaful
The honest truth of the Takaful market in western countries like the UK, is that it is essentially non-existent. It is the space in Islamic finance that I would argue has been given the least amount of attention or investment. It has shown promising growth and development across some of the key Muslim hotspots like the GCC and Southeast Asia, albeit still being an immature market. The UK however currently has no real players in this space, with there only being a few select global brokers, which are not really accessible to retail customers.
There have been previous attempts, with Salaam Halal being the first UK dedicated Shariah motor and home insurance provider back in 2008. They however shortly entered a solvent run-off the following year due to not being able to secure enough of a capital reserve during the turbulent financial crisis. This may have deterred further entrants into this market as the capital requirements were significant and real and the demand did not sufficiently plug this gap.
2008 however was many years ago, and was unique even as far as recessions go. Islamic finance has developed dramatically since then, and demand is ever increasing. I don’t believe this should be a cautionary tale, but rather it simply should be a lesson on practically preparing to enter this market. Salaam Halal did not fail to meet obligations, it went into a phased process of closing down and winding down its assets, not because the model didn’t work but rather because of the capital restraints, caused by the financial crisis.
There is clear headroom for this industry in the UK, and as Muslims become more financially literate and adept, and non-Muslims strive for more ethical financial initiatives, the growth potential becomes more real.
It is clear however that there are some real quirks and practices that the current model adopts that are contentious and not ideal, but given the industry is still quite immature, there is room for improvements in the model as it scales.
With this, there is a lot of promise in Takaful and its potential future growth.
Thanks for reading,
Aqila Finance