the conventional insurance system v takaful insurance system

1Conventional and Islamic Insurance Systems

The Conventional Insurance System versus the Islamic Insurance System

Conventional Insurance System

Most of people have fear and they do not like risk. Happiness is the main

object to the humanity. Making money is an important condition to get happiness and

by investing the money, people can make more money to satisfy their needs. Investing

money involves risk, which increase the return on this money. Generally, investors

prefer to increase the return and decrease the risk. Chinese and Babylonian traders in

the 3rd and 2nd millennium BC practiced one of the earliest methods of transferring or

distributing the risk. Chinese merchants preferred to move their goods by shipping

them on several boats to diversify the risk. Persia was the first country that attempted

to insure its people and made it official by registering the insuring process in

governmental notary offices. The Jewish rabbis claim that The Talmud deals with

several aspects of insuring goods. The Greeks and Romans introduced the origins of

health and life insurance c. 600 AD. In the 14 thcentury, Italian merchants insured their

exports and imports, which were moved from or to Genoa coast. In the late 17th

century, Edward Lloyd opened a coffee house that became a popular meeting place

for the ship owners, merchants, and ships’ captains. Edward Lloyd 's coffee house

became the meeting place for parties wishing to insure cargoes and ships. Because of

the great fire of London in 1680, Nicholas Barbon established England's first fire

insurance company (Dorfman, 2007). The first insurance company in the United

States was established by Benjamin Franklin in 1732, he helped to popularize and

make standard the practice of insurance. In the 17th and 18th centuries, many

companies in London (The center of world trade in 17 century) and U.S.A started to

establish the rules and laws that standardized and formulated the conventional

insurance system.


The insurance company represents the 1st party of the insurance contract and

has a name of the insurer. The 2nd party of the contract represents the customer of the

insurance company and has a description of insured or a name of the policyholder or

policy owner. The insurance contract forces the insurer to protect the policyholder

from the risk of losses and compensate him for these losses. The policyholder should

pay the fees of the insurance policy or the premium to the insurer to get the right of

the compensation of the losses (Dorfman, 2007).

The process of the conventional insurance system is very simple and clear.

The insurance process begins when the policyholder pay the premium to the insurer.

The insurance policy represents the insurance contract and it has a maturity or expiry

date. The policy protects the policyholder from risk of the loss causes by the damage

of the insured property or person. The insurer or the insurance company receives the

premiums from the policyholders and invest them in profitable projects to generate

returns to the insurer. The greatest amounts of the returns go as an income to the

owners of the insurance company, which can be the stockholders of the insurance

company. The rest of the returns go as operating expenses to the insurance company

to complete the insurance arrangements, the policyholders do not have any right in

these returns. The insurer has to compensate the policyholder against any peril, that

causes the loss of the insured property or person during the maturity date of the

insurance policy. Each insurance policy has to identify clearly the types of the perils

that cause the losses to the policyholder. In addition, the amount and the value of the

compensation that is right to the policyholder should be clearly identified in the

insurance policy. The policyholder could trick and make tricky accidents that cause

the losses of the insured property and get the amount of the compensation from the


insurer. This action will repeal the insurance contract, gives the insurer the right of the

premium, and exempt him from the compensation's commitment.

The relationship between the risk and return is an inverse relationship, the

higher the risk the higher the return and vice versa. The insurance as a business is very

risky investment, which requires a very qualified and skilled staff to run the business.

In general, most of the insurance companies make huge amount of profits by

managing the risk of loss (Bodie, Kane, and Marcus, 2007). Most of the insurance

businesses follow the basic four insurance principles to limit the risk of loss. The first

principle is the similarity of a large group of items exposed to the same peril, which

allows the insurance companies to benefit from the law of the large numbers. This

means, as the number of similar items exposed to the same peril increase, the actual

results become more closely to the expected results. The second principle is the

definite and accidental loss, which allows the insurers to identify the time, place, and

location of the peril that result in the loss and just to cover the loss that is out of

control of the beneficiary. The third principle is the calculable loss and affordable

premiums, which allows the insurers to calculate the probability and the value of the

loss and determines the value of the premium according to size of the loss. The fourth

principle is to limit the risk that cause catastrophic losses, which means that t insurers

avoid to issue insurance policy to the events that requires huge compensations like

earthquake policies, hurricanes policies and wind policies (Bodie, Kane, and Marcus,

2007).

Insurance classification is very difficult and confusing. Most authors,

professors and the scientists face the problem of the insurance classification. In

general, insurance can be classified in different methods. Types of the Insurance

according to the insurer can be classified into two types. Public insurance that aims to


help the citizens and support the country. Private insurance that aims to make profits.

Types of the insurance according to the insurance policies and the risks and perils

they cover can be classified to many and unlimited kinds. Insurance policies and

programs that are issued by and supported by the government are four types. The

social insurance policy covers the perils of retirement, disability, unemployment,

illness, and sickness. The agricultural insurance policy covers the perils that threaten

or destroy the agricultural crops. The industrial insurance policy covers the perils that

threaten the national plants and factories. The banking insurance policy covers the

financial perils that threaten the banking industry. Insurance policies and programs

that are issued the private insurance companies are uncountable and unlimited. Private

insurance policies can be classified into several categories; In general, they can be

classified to seven or eight types. Fire insurance policies cover the losses of the real

estate properties and human lives that are caused by the fires. Marine insurance

policies cover the losses of the mobile property; these policies secure the properties

that are moved by ships, trains, planes, and trucks. Causality insurance policies insure

against the accidents that injure the policyholder, this type can be classified to

different categories (Dorfman, 2007). Automobile insurance policies insure against the

car accidents that injure the policyholder and they include financial perils, medical

perils, and liability perils. Health insurance policies insure against the perils that

injure policyholder's health and they cover the policyholder medical costs (Dorfman,

2007). Crime insurance policies insure against the perils that are caused by criminals

or thieves. Disability insurance policies insure against the perils that affect the worker

ability to work to generate an income like accidents of labors and firing perils, these

policies compensate the worker until he can work and generate income again. Credit

insurance policies insure against the perils that affect the borrower ability to pay the


loan payments to the lender. Legal liability insurance policies insure against the perils

that result legal commitments against the policyholder. Life insurance policies insure

against the perils that injure the life of the policyholder like death. Terrorism

insurance policies are the newest kind of the insurance policies and they insure against

the perils and losses which results from terrorist actions.

Terrorism Insurance Policies

Life Insurance Policies

Legal Liability Insurance Policies

Credit Insurance Policies

Disability insurance policies

Crime Insurance Policies

Health Insurance Policies

Automobile Insurance Policies

Causality Insurance Policies

Marine insurance policies

Fire Insurance Policies

Banking Insurance Policy

Industrial Insurance Policies

Agricultural Insurance Policies

Social Insurance Policies

Private Insurance Policies & CompaniesGovernment Insurance policies & Companies

Types of the Insurance Companies and Policies


Standard line or life insurance companies and excess line or nonlife insurance

companies are the main two types of the insurance companies. Life insurance

companies issue life insurance policies, annuity insurance policies and pension

insurance policies. It is very difficult and complicated to manage life insurance

companies because they have long-term commitments and their works are very risky.

Nonlife insurance companies issue different types of policies like property insurance

policies, causality insurance policies and the rest types of the private insurance

policies. Managing this kind of insurance companies is easier than to manage the life

insurance policies because they have short-term commitments and their works is not

risky like life insurance companies. Credibility and reputation are the most important

two elements for the insurance companies because without these two elements the

insurance companies cannot attract the customers to buy the insurance policies. The

legislation in the insurance field is difficult and insufficient. Many laws and legal acts

were issued by financial authorities to regulate and standardize the insurance industry.

Many insurance companies do not respect their commitments to the policyholders and

most of them do not continue in their works. The U.S.A and U.K have the most

creditable insurance companies in the world. American Insurance Group is the biggest

insurance company in the world, which had a total value of assets about $1 trillion in

2007. Today, the global insurance industry grew by 12.3% and had a total value of

assets $ 4.1 trillion. The insurance industry is more developed in the developing

countries than in the developed countries (Bodie, Kane, and Marcus, 2007).

Insurance is useful for the economy and it has many benefits. One of the

greatest benefits which an insurance system rewards society is stability in families.

Insurance prevents from experiencing the great hardships caused by unexpected losses

of property or the premature death of the main income provider. Insurance is also very


useful to businesses. Insurance aids planning process because the planner knows will

not mean financial ruin, and the future of the business cannot destroy by a fire or the

death of a key person. Insurance aids credit transactions. Lenders are more willing to

make property or real estate loans if they know a disaster cannot destroy the financial

security behind their loan. Insurance is also useful for the economy because it

functions as an antimonopoly device. If no insurance system was available, only the

largest businesses could sustain losses and remain in operation. In general, all

financiers recognize that insurance availability tends to lower a firms cost of capital

because both creditors and investors would charge much more for the use of their

money if it subjected to the risks associated with natural disasters in addition to

normal business risks (Dorfman, 2007).

Islamic Takaful Insurance System

Takaful insurance system or Islamic insurance system is the newest insurance

system in the world. It is difficult to talk about Takaful insurance because it is a new

and incomplete or imperfect insurance system. This insurance system has a short

history, not like the conventional insurance system. The Takaful industry is roughly

30 years young. Islam is an old religion that has a long history but no one during this

history discussed the permissibility or prohibition of the insurance because no Islamic

country adopted the insurance or dealt with the insurance officially (Kwon, 2007). Ibn

Abdin (1784-1836) was the first scholar in the Muslim World to discuss the meaning

and legal character of Insurance. Islamicity of insurance has been under discussion

since then. Mohammed Abduh was the first Islamic scholar during the decade that

started to formulate a new Islamic insurance system. In 1965, a group of Islamic

scholars of different mazahib (Islamic schools of thought) met and discussed the

reasons behind the prohibition or forbiddance of the insurance in Islam. In 1972,


meeting of the Islamic Studies Conference (ISC) considered eighty opinions on

insurance submitted by scholars worldwide, but adjourned without making final

recommendations, leaving the topic pending for further study. The first Takaful

company was established in 1979 and it was the Islamic Insurance Company of Sudan

(Kwon, 2007). Today, there are some 28 registered Takaful companies worldwide and

there are 10 more insurance companies' have adopted Takaful programs. Many

countries have adopted the Takaful insurance system like Malaysia, Bahrain, Kuwait,

the U.A.E, Egypt, Saudi Arabia, Pakistan, Australia and Lebanon, the U.K, the U.S.A,

Philippines, Sri Lanka and Singapore. Malaysia is the best country in the Takaful

insurance industry and it has a rate of growth 60% annually (Jones, 2008).

Islamic or Takaful insurance system was adopted as an alternative to the

conventional insurance system. All the Muslims around the world receive the fatwa

from the certified Islamic scholars. Islamic scholars have four sources for the

legislation in Islam. They are the Quran (Islamic holy book), Sunman or Hadith sharif

(Prophet Mohammed's instructions), Ijma'a (consensus of legal Islamic scholars and

Qeyas (justice reasoning in Islam). Sheikh Mustafa Zarqa and many of the legal

Islamic scholars agree that conventional insurance is prohibited in Islam because of

four reasons. These reasons are Al Riba (excess or interest on loans), Al Maisir

(wagering, speculation, gambling) , Al Gharar (uncertainty, deception and unclear

terms) and Investment of premiums by insurers into non-Shariah compliant securities

. Insurance is blamed for Gharar because, at the time of the contract, the insured are

uncertain about occurrence of indemnity, amount occurred in case of indemnity, and

the timing of indemnity. However, supporters of insurance argue that these matters

are unknown only at the individual level, while at collective level, they are

scientifically determined by statistical laws of large numbers, actuary, and probability.


Insurance is blamed for Maisir because the policyholders are seen to bet premiums on

the condition that insurer will make compensation payments (indemnity) of the

happening of specific event. The advocates of insurance argue that insurance is the

contract of indemnity, which is altogether different from gambling. A specific event

must occur by the appointed time and one of the parties must win or lose in gambling.

In the case of insurance, the specified event may or may not happen during the policy

period. Riba refer transaction involving unequal exchange of the same thing.

Insurance is viewed as un equal exchange of money in premiums and compensations.

In fact, money paid in premiums do not equal the money received in compensation.

The insured or the policyholder receives less or nothing when the policyholder

withdraws the policy, defaults on premium, does not experience peril, the insurance

contract is declared void due to any other reason. Compensation received from

insurers may be is greater than the premiums if a peril occurred. Here we have a riba

because the insured receives compensation that is higher than his premium. While in

the other side, when there is no happening of perils, the insured does not receive any

compensation, which results a profit for the insurer. The advocates of the insurance

argue that there is no riba in insurance because of several reasons. The money

received in claim by the insured (compensation) depends on the extent of financial

loss incurred in consequence of a peril. Individuals engage in riba transactions with

the sole purpose of monetary gains, while the purpose of the insurance policy is to

protect, not to enhance the financial position of the insured. Insurance is also essential

part of banking and international trade transactions. Insurance is illegal because the

compensation is given to nominees, which is contrary to the Islamic laws of

inheritance.


Takaful insurance system is based on three principles. Mutual responsibility,

which means the feeling of responsibility towards one another. Mutual Co-operation,

which has the same meaning of this Hadith (Prophet Rule) "The relationship between

one believer and another (in a community) is like that of a building where one part of

the building strengthens the other parts." (Mutafaq 'alaihi). Mutual cooperation for the

protection of members in the event of loss.

There are five crucial elements that are very important and required to

formulate Takaful insurance. Ne'aa (intention) or utmost sincerity of Intention for

knowingly following the guidance and adhering to the rule and purposes of Takaful -

cooperative risk sharing and mutual assistance. Integration of Sharia conditions,

namely risk sharing under Ta'awuni (collaboration and cooperation) principles,

coincidence of ownership, participation in management by policyholders, avoidance

of Riba and prohibited investments, and inclusion of al Mudharaba. Presence of Moral

Value and Ethics. No Unlawful (illegal action or item) Element that contravenes

Sharia (Islam rules). Appointment of Sharia Advisory Council or Committee to

oversee the development and Islamic auditing of the Takaful operations.

Takaful is an alternative form of insurance. Consequently, many of the

principles and practices of insurance equally apply to Takaful. General Takafuls are

short-term contract for protection of potential material losses resulting from specified

catastrophes. Participants' installments are called tabaru (donation). Amount of

Takaful contributions varies, as in insurance, according to the value of property to be

covered under the general Takaful scheme. Company invests the tabaru funds, and the

profits accrued there from are allocated between the fund and the management on the

basis of mudaraba. Indemnity is paid out of the tabaru fund. Operational costs

including reinsurance costs and other reserves are also deducted from tabaru fund. If


the fund generates net surplus then, unlike insurance, surplus is shared between

participants and the company. In sum, in case of general insurance, there is no

substantive difference between tabaru and the premium from the insured point of view

as the entire contributions of the participants are treated tabaru, like premium in

insurance (Dirrheimer & Sohail, 2008). The contribution, like premium, depends on

the value of the property to be

covered. However, unlike insurance, Takaful participants are entitled to surplus in the

tabaru fund, if any. Islamic life insurance is organized in the name of family Takaful.

Premiums, unlike insurance, are determined by the participants themselves depending

on their financial strength. Installments paid by the participants are divided into

Takaful, also called tabaru. The proportion for tabaru fund, like insurance, is

calculated on actuarial basis, which varies according to the age and participation

period of the participants. Insurance benefits are paid from the tabaru fund.

Participants pledge to make additional contributions if Takaful fund proves

insufficient. However, in reality, companies prefer to carry such deficits forward till

the Takaful fund enjoys surplus. In the meanwhile, companies finance the deficits on

the basis of interest free loans. The actual operating expenses are charged from the

Mudarabah accounts. Participants are entitled to reimbursements upon maturity,

withdrawal and, in some cases, upon disablement. Upon the death of a participant, his

profit shares are entitled to Takaful benefits. The Takaful benefits are reimbursed

according to the Islamic inheritance. If a participant withdraws before the maturity of

contract then money in the investment account is paid as surrender benefits. In the

case of the death of a participant, his heirs are entitled to full value of the decreased

participant's share in mudarabah investment account plus money equal to all unpaid

installments, due to be paid in future if he lived, from the Takaful account.


Participants cannot interfere with management activities as the management assumes

full authority. However, if a loss occurs due to disrespect of modarabah conditions,

the Takaful companies will bear those losses.

Takaful operations in the insurance primary markets can be broadly classified

into one of the three models: a mudarabah model, a wakala model, and a hybrid

model. With the mudarabah model, both the policyholder and the insurer share profits

from Takaful operations. With the wakala model, there is a complete separation

between the insurer's capital and the policyholder's fund and the insurer receives a

fixed fee for managing/investing the fund on the policyholders' behalf; that is, all

profits from Takaful operations less fixed fees for underwriting and investment

services belong exclusively to policyholders. Under the hybrid plan, the insurer may

use a mudarabah model for underwriting activates and a wakala model for investment

activities. It is worth a little that operating losses are born only by policyholders in all

three models. In all Takaful models, insurers use their capital (shareholders' fund) to

provide interest-free loans to cover deficiency in the policyholders' fund. Reasonably,

all net gains and losses from investing the insurer's capital are of the insurer's own.

On the other hand, some Malaysian professors argue against the previous

classification and they suggest another model of Takaful classification (Kwon, 2007).

This Malaysian classification provides three types of Takaful insurance models. Non-

Profit Model includes social-governmental owned enterprises and programs operated

on a non-profit basis. Al Mudharaba Model, whereby cooperative risk sharing occurs

among Participants yet the Takaful Operator shares also in any operating surplus as a

reward for its careful underwriting on behalf of Participants. Al Wakala Model,

whereby cooperative risk-sharing occurs among participants with a Takaful Operator

earns a fee for services (as a Wakeel or Agent) and does not participate or a share in


any underwriting results as these belong to Participants as Surplus or Deficit, operator

also charge a funds management fee (Dirrheimer & Sohail, 2008).

Takaful insurance system is one of the most dynamic areas of the boarder

market for Islamic financial services. As Moody's noted in a recent report, Takaful

has shown very impressive premium growth rates of about 20% in recent years. Total

Takaful has exceeded 2$ billion in 2005, and are expected to reach $7.5 billion by

2015. The famous economist, Fitch, puts the total global Takaful contributions at

about $2.6 billion (Jones, 2008). The Takaful insurance share in the insurance markets

is vey small compared with the world's insurance sector as a whole. But the Takaful

insurance industry will extend beyond its current size and there is substantial potential

for growth both in Muslim communities in the Middle East and Asia as well as in

some more mature markets (e.g., in France, Germany, UK, U.S.A, Canada, Spain,

Russia,….etc), which have significant Muslim minorities and significant desired

customers (Ashton, 2008).


Note. The data on Takaful Potential Distribution are adopted from " Islamic Principle and Takaful

Insurance: Re-evaluation" by W. J. Kwon, 2007, Journal of Insurance Regulation, 26, pp. 53-81.

Retrieved from Ebsco database (2007-30856-681). http://info.euromoney.com.

Comparison between the Conventional Insurance and the Takaful Insurance

A comparison is made below to highlight the salient differences between

conventional insurance and Takaful insurance:


Conventional Insurers Takaful OperatorsSources of laws & regulations are set by

state and man-made.Sources of laws are based upon Divine revelations (Holy Quran and Hadith)

Profit-motive, maximizing returns to shareholders.

Community well-being optimizing operations for affordable risk protection as well as fair profits for the operator.

Profits and/or Bonus units to be returned to policyholders as determined by managers

and Board of insurer.

Takaful contract specifies in advance how and when profit/surplus and/or

Bonus units will be distributed .

Initial capital supplied by shareholders.Initial capital supplied by Rabb al Mal (Agent) or paid in via premiums from

participants.

Separation of policyholder and insurer with differing interests.

Coincidence of interests between policyholder and operator as appointed

by participants.

Transfer of losses among insurance pools and from policyholders to shareholders.

Losses retained within classes of business written and sole obligation of

Participants.

Right of insurable interest is vested in the Nominee absolutely in Life insurance.

Right of insurable interest is determined by Islamic principles of Faraid

(inheritance).Insured may elect cost or replacement cost valuation and claim accordingly whether or

not they chose to rebuild property.

Insured may not "profit" from insurance and entitled to compensation only for

repair or rebuild or replacement.Agents and Brokers are typically

independent from insurer and paid a fee from the premium charged to policyholders that is

not disclosed that is not disclosed.

Agents are employees of the Takaful and any sales commission should be

disclosed.

Investment of premiums conducted by insurer with no involvement by

policyholders.

Takaful contract specified under principles of al Mudharabah how

premiums will be invested and how results are shared. Under al Wakalah, similar practice plus Participant can direct his investments into a range of

unitized funds.Insurer invests premiums consistent with profit-motive with no moral guidelines;

hence co-existence of Al Riba and Al Maisir.

Takaful invests premiums in accordance with Islamic values and

Shariah guidelines.

Dissolution - reserves and excess/surplus belong to the shareholders.

Dissolution - reserves and excess/surplus could be returned to

Participants, although consensus opinion prefers donation to charity.

Taxes - subject to local, state, and federal taxes.

Taxes - subject to local, state and federal taxes (if any) plus obligated to arrange annual tithe (Zakat) donations

to charity.Benefits paid from general insurance account

owned by insurer.Benefits paid from contributions(Al

tabarru) made by participants as mutual


indemnification.

Accounting consistent with GAAP and prevailing statutory rules Auditing for

uniform application of accounting standards.

Accounting standards consistent with national rules (with may be GAAP)

plus prevailing statutory rules. Auditing same standards plus conformance with

Islamic rules; typically with Sharia Advisory oversight.

Conclusion and Recommendation

Insurance, especially life insurance is an essential part of the social protection

needed for any society. It has its rightful place in Islam but years of misunderstanding

and misconception have created mental blocks against insurance in the Muslim

culture. I believe Takaful or Co-operative Insurance is the right way forward towards

the breakdown and removal of such mental blocks. This type of insurance has great

deal to offer in Muslim countries where the spread of insurance per person and per

Syrian pound of GDP can increase manifold if the system of Takaful is projected

correctly and understood properly. It can genuinely enlarge the insurance market in

areas where traditional insurance has not been able to grow, as it should have done.

This is true of personal lines, especially of life insurance or family Takaful.

In order to create the essential trust and confidence, which is needed to remove

the mental blocks just mentioned, the efforts to develop and manage Takaful business

must be genuine. Investors, entrepreneurs, and insurers have good opportunity to take

up the challenge of developing insurance business on Islamic principles. After all

Takaful is intrinsically in accordance with the indigenous consumer needs.

References


Ashton, M. (2008). Islamic market presents challenges. Journal of Fin Week. 17 (2),

64-65. Retrieved from Ebsco database (2008-34383-663).

Bodie, Z., Kane. A., & Marcus, A. (2007). Essentials of Investment. United States:

MCGraw-Hill.

Dirrheimer, M. J., & Sohail. J. (2008). The potential of Bancatakaful. Journal of

Financial services. 39 (2), 14-15. Retrieved from Ebsco database (2008-30059-281).

Dorfman, M. S. (2007). Introduction to risk management and insurance. Canada:

Pearson-Prentice Hall.

Insurance. (n.d). Retrieved June 2, 2009, from the WiKIPEDIA Wiki:

http://en.wikipedia.org/wiki/Insurance

Jones, M. (2008). The Next Step. Journal of Global Insurance. 109 (6), 145-148,

Retrieved from Ebsco database (2008-34928-004).

Kwon, W. J. (2007). Islamic Principle and Takaful Insurance: Re-evaluation. Journal

of Insurance Regulation. 26 (1), 53-81. Retrieved from Ebsco database (2007-30856-

681).

Takaful. (n.d). Retrived June 2, 2009, from the WIKIPEDIA Wiki:

http://en.wikipedia.org/wiki/Takaful

the conventional insurance system v takaful insurance system

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