Takaful Corner

A Guide To Islamic Finance

Islamic insurance, or ‘takaful’, is an alternative to conventional insurance and offers a shari’a-compliant option that may also appeal to those looking for an ethically driven insurance provider.

Takaful is an Arabic word meaning “guaranteeing each other”

When it comes to conventional insurance, there is a general consensus among Muslim scholars that there are contradictions with essential elements of an Islamic financial contract. A takaful contract must be based on principles of cooperation, protection and mutual responsibility, but must avoid acts of interest (riba), gambling (al-maisir) and uncertainty (al-gharar).

Although there is not one preferred or standard operating model for takaful insurers on a global scale, shari’a scholars generally agree on certain fundamental components that are required to be an accepted takaful company. However, operational differences are tolerated as long as there is no contradiction to any essential religious tenets.

Togetherness in striving for the common good
Participants agree to reciprocally guarantee each other against certain loss or damage that may be inflicted upon any of them. This embodies the principle of mutuality, solidarity and brotherhood among the participants in striving for common good.

Establishment of a shari’a board
An essential component in a takaful company’s corporate governance is the establishment of a shari’a board, in addition to the conventional board of directors. The shari’a board is made up of Islamic scholars, who ensure the company’s operational model, profit distribution policies, product design and investment guidelines comply with Islamic principles.

Restricted investments
Shari’a compliance refers not only to the operational structure of the company, but also to its investment policy. Takaful companies must avoid investing in traditional fixed-income securities (due to the coupon interest payment attached). Instead, they are allowed to invest in sukuk (or Islamic bonds, where coupon payments take the form of a profit share on a particular enterprise). Moreover, investments in stocks (in principle allowed) should avoid the financing of non-Islamic activities (such as alcohol or gambling).

Establishment of two separate funds
A takaful (or policyholders’) fund and an operator’s (or shareholders’) fund. The takaful fund operates under pure cooperative principles, in a very similar way to conventional mutual insurance entities. Underwriting deficits and surpluses are accrued over time within this fund, to which the operator has no direct recourse. As a result, the takaful fund effectively is ringfenced and protected from default of the operator’s fund.

Management expenses and seed capital are borne by the operator’s fund, where the main income takes the form of either a predefined management fee (to cover costs) or a share of investment returns and underwriting results (or a combination of both).

Solidarity principle and surplus distribution:
Given the fact that the takaful fund is seen as a pool of risks managed under solidarity principles, it is not meant to accumulate surpluses at levels excessively higher than those strictly needed to protect the fund from volatile results and to support further growth. Likewise, any fees or profit shares received by the operator should be just sufficient to cover management and capital costs while keeping the company running as an ongoing concern.

In case of financial distress for the takaful fund, the operator is committed to provide it with an interest-free loan, Qard’ Hasan, for however long it is deemed necessary – providing an additional layer of financial security to the participants.

The surplus distribution structure is expected to be managed carefully and in a balanced way, so that neither policyholders nor operator make excessive profits at the expense of the other party.