Takaful and Conventional Insurance: A Comparative Study

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Takaful and Conventional Insurance: A Comparative Study

Merazga Hachemi¹, Ali Ahmoudah Mohamaed², Radwan Oun Eshebani³, Maysarah Abd Aziz⁴, Wan Julia Wan Abd Ghani⁵, Muhammad Ridhwan Ab. Aziz⁶

Abstract

Maslahah hierarchy shows that maqasid shari'ah must prioritize five things: religion, life, intellect, honour and property. Social responsibility also explained that each individual is responsible for the property to be maintained, managed, and developed. Takaful is one ofthe methods that can be used for this purpose based on the contract and the application of savings for self and for emergency usage on others. The objective of this paper is to compare between Takaful and conventional insurance in terms of concept, comparative advantage, and application in the market. The methodology of this article is through qualitative research based on document analysis on relevant literatures. The general findings of this article show that there are obvious differences between Takaful and conventional insurance in protecting individual and society.

Keywords: Takaful, Conventional Insurance, Aqilah, Tabarru’, Mudharabah, Wakalah, Riba, Gharar, Maysir

1. Introduction

In everyday life, every human being will always be a risk of injury, damage, or accidents. In order to face those risks, a person needs to anticipate loss and reduce the effects of adverse situations.

The basic idea of an insurance agreement is that it is a mutual co-operation between two parties to protect one of them from unexpected future financial loss. Under conventional setup the main viewpoint of insurance is to minimize the risk. Pfeffer (1956) defines insurance as a device for the reduction of risk of one party, called the insured, through the transfer of particular risks to another party, called the insurer, who offers a restoration, at least in part, of economic losses suffered by the insured.

Takaful, the Islamic insurance is based on the idea of social solidarity, cooperation, and joint indemnification of losses of the members. Takaful is founded on the cooperative principle and on the principle of separation between the funds and operations of shareholders, thus passing the ownership of the Takaful fund and operations to the policyholders. In Takaful, the policyholders are joint investors with the Takaful operator, who acts as a mudarib – a manager or an entrepreneurial agent for the policyholders. The policyholders share in the investment pool's profits as well as its losses. The main purpose of Takaful under the Islamic system is to bring equity to all parties involved, and the objective of the contract is to help the policyholder through bad times. (MherMushtaqHussain and Ahmad Tisman Pasha,2011).

Basically,the basic idea of Takaful is similar to conventional insurance. Both are aims to provide protection to individuals or corporate bodies from occurrence of loss and hazards, which it is a mutual financial transaction to safeguard against unexpected risk. These two contracts have the common objective of reducing a financial burden arising from any disaster or accidental loss like fire, flood, or storm.

(Mohammad, 2008)

1Faculty of Economics and Muamalat, University Sains Islam Malaysia, Negeri Sembilan, Malaysia

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544 Takaful needs to be operated within Islamic principles which it must be Shariah compliance. Therefore, in conducting the business, all the transactions of Takaful must be free from the elements of riba, gharar, andmaysir. Based on the concept, it is clear differences between the Islamic insurance and the conventional insurance. Thus, this paper will focus on the conceptual and operational difference between these two types of insurances; the Takaful (Islamic Insurance) and the conventional insurance.

2. Concept of Takaful

The idea of Islamic insurance or Takaful is based on the concept of Al-Aqilah, which had been practiced by the ancient Arab tribes before 570CE. During that time, if any member of a tribe was killed by a member of another tribe, the heir of the victim will be paid an amount of blood money as compensation by the close relatives of the killer. Therefore, the central idea of Al-Aqilah is to make money contributions to pay for the compensation. Al-Aqilah concept is similar to the indemnity in today’s insurance practices as it is a kind of financial protection for their heirs against an unexpected death of the victim. The practices of Al-Aqilah then obtained recognition in Islamic law based upon the approval of the Holy Prophet Muhammad (PBUH). This can be seen in one of his judgements against a woman from the tribe of Huzail.

“Narrated by Abu Hurairah(r): he said that once two women from Huzail clashed when one of them hit the other with a stone which killed her and her fetus in the victim’s womb. The heirs of the victim brought an action to the court of the Holy Prophet (s.a.w), who gave the verdict that the compensation of the fetus to be a male or female slave while the compensation for the victim woman is a blood money (Diyat) to be paid by the Aqilah (the paternal relatives) of the killer.”

(Sahih al- Bukhari) Subsequently, the development of the concept of Al-Aqilah being developed and re-organized during the period of the second Caliph Saydina Umar (r.a).

Takaful in Arabic means joint guarantee. Takaful can also be visualised as a pact among group of members or participants who agree to joint guarantee among them against loss or damage that may inflict upon any of them as defined in the pact. Islamic insurance policy which is Takaful is based on concept of mutual help and co-operation in providing material security for the insured against an occurrence of an unexpected peril or loss. Few references in the Quran and Hadith has emphasised on mutual co-operation.

Quranic Verse:

"…and help one another in righteousness and piety,but do not help one another in evil deeds and enmity" (Al Maidah(3):2)

Hadith:

“Narrated by Abu Hurairah(r), the Holy Prophet (s.a.w) said: “Whosoever removes a wordly hardship from a believer Allah (s.w.t) will remove from him one of the hardships in the hereafter…” (Sahih Muslim, as compiled in al-Nawawi, Forty Hadith)

In Takaful transaction, there are four parties involved namely the participant, the operator, the insured, and the beneficiary. The participants are those who contribute the mutual fund whereas the insured are those who are among the participants that face the risk and being assisted by the fund. The monetary contribution made by the participants to the fund is known as mutual contribution and those who gained benefit from the co-operative fund is known as beneficiaries. The fund is managed by the Takaful operator, which is formed through registered, licenced body or cooperation who binds himself unilaterally to manage the fund according to Shariah principles. In general, each member of the group pools effort to support the needy and it means mutual help among the group. Should any member or participant suffer a disaster or catastrophe he will receive a certain sum of money or financial benefit from a fund as defined in the pact to help him meet the loss or damage. The basic objective of Takaful is to pay for a defined loss from a defined fund. Therefore, the Takaful operator need to maintain adequate assets of the defined funds under its care whilst simultaneously

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545 striving prudently to ensure the funds are sufficiently protected against undue over exposure.(http://www.bnm.gov.my/)

The operation of Takaful is under a legal responsibility to provide the participants with the financial security against unexpected losses or damages, which occurred within the agreed period of the policy. The contribution by the Takaful participants is based on the concept of mutual assistance. The concept of tabarru’

is incorporated in Takaful practices. The word tabarru’ means to donate, to contribute, or to give away. Thus, by applying tabbaru’ concept, certain proportion of the participant’s contribution or instalments that he agrees or undertakes to pay thus enabling him to fulfil his obligation of mutual help and joint guarantee should any of his fellow participants suffer a defined loss (Mohd FadzliYusof, 1996). Tabbaru’ concept brings to charitable contract based on the fact that, every participant guarantees each other. In essence, the concept of tabarru’ would enable the participants to perform their deeds in sincerely assisting fellow participants who might suffer a loss or damage through incident or disaster.

Basically, Takaful can be implemented through al-Mudharabah and al-Wakalah model. The Takaful operator is the administrator of the fund and manages the fund in trust on behalf of the participants, and the contract between participants and the operator is governed under the contract of mudharabah or wakalah.

Under the mudharabah contract, the Takaful operator acts as a mudharib (entrepreneur) and the participants as rabbul mal (capital providers). The Takaful operator runs the business with the accumulated money that contributed by the participant. Both the operator and the participant will share the profits earned from such transaction accordingly. Thus, Takaful is based on the concept of shared responsibility and co-operation.

Mudharabah is a profit and loss sharing scheme where it gives the right to the contracting parties to share profit, while liability for loses is borne by the participant. Losses are borne by the participants as the capital providers. However, to protect the interest of the participants, the Takaful operator is required to observe prudential rules including provision of financing rate-free loans by the operator to the Takaful risk funds in the event that there is a deficiency in the Takaful risk funds. The wakalah concept is essentially an agent- principal relationship, where the Takaful operator acts as an agent on behalf of the participants and earns a fee for services rendered. The fee can be a fixed amount or based on an agreed ratio of investment profit or surplus of the Takaful funds. (http://www.islamicfinanceinfo.com.my)

In carrying out the Takaful operations, Shariah requires the transaction to be free from riba, gharar, maysir, and other prohibited activities. It is prerequisite for the validity of a Takaful contract that none of its aspects should contravene any express or implied Shariah principles. Riba (usury) or interest is any excess of profit on a loan for a deferred payment when the borrower is unable to repay it after the fixed period and similarly any excess or profit on a loan at the time of contract. The practise of Riba will distort equitable distribution of wealth and perpetuate socio-economic injustice. The Shariah prohibits both the taking and paying of interest (Riba) no matter what the purpose of the transaction, or the amount of interest charged. The wealth must be gained from legitimate resources through either trading profits or investment returns (Mustafa,Zurina,Supiah and Nurazalia, 2012).

Maysir (gambling) means anything that has risks. In addition, maysir can be in the form of ghararwhen something has the probability of either to be existence or otherwise. Islamic scholars have stated that maysir (gambling) and gharar are inter-related. Where there are elements of gharar, elements of maysiris usually present. Maysir exists in an insurance contract when; the policy holder contributes a small amount of premium in the hope to gain a larger sum; the policy holder loses the money paid for the premium when the event that has been insured for does not occur; the company will be in deficit if the claims are higher than the amount contributed by the policy holders. (http://www.islamic-banking.com)

Gharar technically means exposing oneself to excessive or unnecessary risks and danger in a business transaction as a result of uncertainty about terms of the deal. In general, it can be referred to as the consequence or outcome that is uncertain. IbnTaimiyah, a leading Muslim scholar, further reasoned “Gharar found in the contract exists because one party acquired profit while the other party did not”. The prohibition on gharar would require all investment gains and losses to eventually be apportioned in order to avoid

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546 excessive uncertainty with respect to a return on the policyholder's investment. (http://www.islamic- banking.com)

Takaful or Islamic insurance differs from what have been applied by conventional insurance. It is fundamental the transaction need to be carried out subject to the Islamic contractual laws in order to ensure its compliance with the Shariah. Takaful is designed to provide protection and indemnity to both individuals and corporate bodies against loss or hazards to themselves or properties. The Takaful model is based on the principles of mutual cooperation and solidarity that have been emphasised in the Hadith:

“Allah will always help his servant for as long as he helps others.”

(Narrated by Imam Ahmad and Imam Abu Daud)

3. Concept of Insurance

Insurance in general sense is transferring the risk from a party be it an individual, an organisation or company to insurance company for a certain payment of premium. It is the most practical method of handling a major pure risk. (Hendon Redzuan, RubayahYakod, Mohamad Abdul Hamid, 2006)

Through insurance system, the insurance company is also known as the insurer, while the insurance buyer is called the insured or the policyholder. An insured is required to pay premium at the inception of the contract. Premium is the price of insurance protection and service rendered from the insurer. In the event of a loss occurring, insurance company is obligated to pay compensation as specified under the insurance policy.

The compensation paid out to the insured or his beneficiaries is called insurance benefit.(Zuriah Abdul Rahman & Hendon Redzuan, 2009)

Insurance is an economic institution founding on the pillar principle of reciprocity, formed for the purpose of establishing a general fund. The need arises when unexpected risk occurred, which the probability of such risk to happen can be reasonably calculated. In financial term, insurance defined as redistributing the cost of unexpected losses. (IBFIM, 2011)

Fadzli Mohd Yusof (1996) states that the insurance can be understood as a group of people vowed to collect and galvanizing effort and resources to establish alliances for mutual cooperation and responsibility, to bear one another, if destined to any of them misfortune befalls. Through this alliance, the unfortunate people affected will get coverage benefits that are usually a certain amount of money. With such benefits, it expected to alleviate the suffering of those involved, usually those dependents who have to borne the consequences of such misfortune.

In other words, insurance can be defined as “a financial arrangement whereby an individual substitute a small certain cost (the premium) for a large uncertain financial loss (the contingency insured against)”

(Vaughan, J.E and Vaughan, T., 2001). Meaning that, insurance is an arrangement whereby an insured purchase a plan that covers specified risks and losses. When an insured purchases insurance, he is required to make premium payments. In returns, he receives an insurance protection. Insurance protection is essentially a promise made by the insurer that in the event of a loss, the insurer shall compensate the insured or his beneficiary. The insurer is required by the law to fulfil the obligation to pay insurance benefit should the insured loss occurs. An insurance arrangement typically includes three distinct characteristics; risk transfer, risk reduction and loss sharing.

i. Risk transfer is an insurance allows the risk faced by the insured to be transferred to the insurer who is financially stronger to pay for a loss than the insured.

ii. Risk deduction is an insurance system permits insurer to predict future losses with reasonable accuracy. The future losses can be predicted, then risk can be reduced.

iii. Loss sharing means spreading the losses incurred by the unfortunate few over the entire insurance pool. (Zuriah Abdul Rahman & Hendon Redzuan, 2009)

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547 This characteristics is essential in order to understand how insurance works.

There are two main types of insurance; life and general whereby these two are different in their natures and characteristics.

i. Life insurance is a coverage that pays a sum of money to the policyholder or the nominee in the event of anything untoward happened to policyholders, such as death. Typically, the life insurance coverage is more than a year. This means periodic premium payments, monthly, quarterly, or annual basis, to be settled.

Risks covered in this type are death during the policy term, income during retirement, illness, and disability.

The main products include whole life policies, endowment policies, endowment policies, investment- linked policies, annuity policies, and medical and health policy.

ii. General insurance is an insurance policy that protects the insured against any loss or damage suffered that not covered in life insurance. For complete coverage, the insured must understand the risks covered to ensure the insured and beneficiary protected from any unexpected events. The coverage period for most general insurance policies and plans is a year that requires a lump sum premium payment.

The risks covered by general insurance of property due to fire or theft, liability arising out of damage to third parties caused by the insured, accidental death or injury.

The main products of general insurance policies including vehicle, fire policy/ owners/ household, personal accident policy and medical and health policy.

There are three principles applied in the conventional insurance; insurable interest, full and absolute trust and indemnity.

Insurable interest

Insurance buyer should have a stake in goods or lives insured where a loss or damage to property or life insured will result in a financial loss to the buyer. For example, if the insured selling his car, the insured also should stop insuring it because the insured no longer has an insurable interest. If the insured continue to insure, the insurance company will not pay compensation to the insured in case of loss or damage to the car.

Full and absolute trust

An insurance contract is a contract on the basis of good faith.

Insured as a policyholder, must disclose all material facts when buying a policy. If failed, the insurance policies purchased may be invalid.

Indemnity

Indemnity means the payback of loss in the form of cash, goods, or the cost of the damaged building.

The principle of indemnity is based on three notions; i. Contribution - each insured and insurer share such agreed payment, ii. Subrogation - the insured cannot claim damages from the other party once insurer has paid the agreed amount and iii. Doctrine of proximate cause - the damages paid to the insured risks only.

(http://www.insuranceinfo.com.my)

Insurance is an economic device, which a group of individuals transfer risk in order to combine experience, which permits mathematical prediction of losses, and provides for payment of losses from fund contributed by all members of the group. It is an arrangement that redistribute the cost of losses through payment of premium in return for a promise to receive compensation in the event of a loss. (Zuriah Abdul Rahman, Hendon Redzuan, 2009).

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548 4. Differences between Takaful and Conventional Insurance

Even though Takaful and insurance have common objective of reducing a financial burden arising from any disaster or accidental loss, there are still differences in the underlying concepts between both contracts.

As being discussed earlier, Takaful is based on the idea of solidarity, cooperation, and joint guarantee in the face of any disaster losses. It is an agreement among a group of persons who agree to jointly share responsibility of loss or damage that may inflict upon any of them; out of the fund they donate collectively but in conventional setup loss is indemnified by the insurance company according to the terms and condition of the policy (Maysami et al., 1997).

Takaful is based on the concept of mutual indemnity in providing protection and compensation to the participants who suffered from perils or hazards (Muhammad 2013). On the other hand, conventional insurance is a device for the reduction of risk of one party, called the insured, through the transfer of particular risks to another party, called the insurer, who offers a restoration, at least in part, of economic losses suffered by the insured (Pfeffer, 1956). In insurance, the risk is transferred from the insured to the insurer.

The other main difference in insurance is it is not bound to Shariah principles as Takaful. In Takaful, all the activities should not have the elements of riba’, gharar and maysir. However, according to Muhammad Nejatullah Siddiqi (1985), the three elements (riba’, gharar and maysir) present in conventional insurance that do not comply with Shariah:

Al-Gharar

This refers to 'unknown' or 'uncertain' factors in a conventional insurance contract. In conventional insurance policyholders are not informed on how profits are distributed and in what the funds are invested in.

In a Takaful operation, this is based on the Mudharabah concept, the distribution of profits to the operators and the participants are clearly outlined in the contract.

Al-Maysir

This is the 'gambling' element and is said to derive from the 'Gharar' element. In conventional insurance the policyholder stands to lose all the premiums paid if the risk does not occur. On the other hand, he stands to get more should a misfortune happen whilst paying a small amount premium. In Takaful, even though the risk does not occur, the participant is entitled to get back the contributions that he has paid. Should the risk occur, he will be paid from his premium fund plus the pool of funds from the 'donation' of other participants.

Riba’

This refers to the interest factor present in the investment activities of conventional insurance companies. The policy loan in conventional life insurance is in fact a riba based transaction. Islam prohibits any investment activities that are interest based.

Daud Bakar (2000) asserts that, Takaful is differs from conventional insurance in the sense that the company is not the insurer insuring the participants. The persons participating in the scheme mutually insure one another and this is the very essence of the word Takafulin Arabic. The operational framework of conventional insurance is based on “risk assumption” but Takaful operate under mutual co-operation basis. It means that, Takaful is a scheme or a social program for the collection of funds for the aid of participants in contingent future.

Furthermore, the conceptual difference between Takaful and conventional insurance is that the risk in Takaful is not exchanged by way of contribution payments made to operator, which means operator is not selling and participant is not buying any risk coverage (Omar and Dawood, 2000). The operator in Takaful acts as fund manager. They will manage the fund contributes by the participants and therefore the operator is not undertaking risk. The risk is however, distributed among the participants who agreed to jointly assume the risk (Yusof, 1996).

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549 In insurance, the initial capital is contributed by the shareholders meanwhile in Takaful, the fund is supplied by rabbul mal (policyholders). Investment of the premium in insurance is conducted by insurer without involvement of policyholders. Meanwhile in Takaful, the business activities are being conducted either through mudharabah model (profit sharing) or wakalah model (agent-principal relationship). In Takaful operations, the capital is invested in investment funds that must Shariah compliant but investment of insurance capital not subject to Shariah compliant.

Takaful is not mainly a profit-making activities, but it most focused on the issue of the community in helping the others. The operations of Takaful is emphasised on the concept of mutual protection and shared responsibility. Therefore, the society will be exposed to moral values of helping and caring for the ummah.

Hence, Takaful concept is the best way to resolve society needs in facing any risk throughout daily life.

5. Reasons Why Takaful is Better Than Conventional Insurance

The following are reasons why Takaful is better than conventional insurance:

i. Takaful is more just than conventional. This can be seen from the definition and objectives of takaful for joint action to protect and help each other out in the community by investing in the tabarru’ fund which depends on certain risks and shariah-compliant. Takaful and conventional insurance have the same goal which is to manage and mitigate the risk. However, fundamental difference in the initial contract set the takaful apart from insurance. Takaful based on risk-sharing among the participants which is fairer than conventional that applies a risk transfer from the participants to the company. Transfering the risk could only jeopardise the participants if the company goes into a limbo and not able to make up with the promises to pay.

ii. Takaful fund management is using a concept called mudharabah or literally translated into cooperation between parties. This concept rightly applies with takaful in which participants provide the capital and takaful companies will manage and profit distribution will based on consensus and pre-agreed upon. No elements of riba (interest), gharar (uncertainty of funds availibility) and maysir (gambling) that cause oppression, injustice and loss to participants that sometimes do happen with insurance.

iii. Unutilized takaful fund usually will be distributed back to the participants. This happen when the actual operational cost etc is lower than the budgeted one thus the need to return it. However, operational cost totally borne by the policyholders thus unlikely any excess of fund exist and considered as forfeited funds.

iv. Basic concept of takaful that applies profit-sharing ensure any additional gain from investment from the fund is equally shared as per agreement. This is not the case with insurance as the concept of selling/

buying of policy and whatever accumulated from the investment are company’s 100%.

v. Takaful activities readily more helpful in boosting the economy for all parties not limited to the company only. Participants enjoy benefits that not listed under insurance that also assist their economic needs. This is more helpful while trying to achieve purpose of life which is to find, manage and use the property for God. (Mohd. Izhar Ahmad, Tariq Masood & Mohd Saeed Khan, 2010)

6. Issues and Challenges Faced By Takaful Industries

There are few main issues and challenges mainly faced in the Takaful operations. Some of the issues and challenges are as follows:

Human Resource Development

As the Takaful business has the potential in market growth, there is a need in developing the human resource with skills and knowledge of Takaful. In todays business, there is still lack of experts in supporting the Takaful business. Continuos training plan need to be developed to produce human resource knowledgable in Takaful and insurance as well as in Shariah. Business in Takaful is now expanding, thus the supply of human resource with expertise in Takaful need to cater for the market demand.

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550 Awareness

Lack of awareness is another issue in conducting Takaful business. Takaful is not only meant for the Muslims, thus, the effort should be broad and borderless. To create awareness, the Islamic financial institutions play a significant role in developing and implementing Takaful concept through the entire world.

Forums and other platforms should be used to address educational issues surrounding Takaful besides effective marketing strategies in order to create awareness.

Product Development

Product development is fundamental in ensuring the business growth. Thus, the study of consumer needs and how to meet the needs is essential in developing new products. Development of innovative takaful products will attract more consumers and thus will benefits the society. The research and development of Takaful product must be conducted by an advice of scholars in order to ensure the product is Shariah compliant.

Investment Option

In Takaful, all the activities should avoid the elements of riba’ (usury), maysir (gambling) and gharar (uncertainty). It is a big challege for the operator to ensure all the activities is Shariah compliant. On management perspective, it is the interest to maximize the shareholders’ values which could create potential conflict from shariah-compliance aspects. There could also be conflict of interest that regarding management of assets invested in related companies.

7. Conclusion

In conclusion, everyone is exposed to the possibility of risks and disasters. Despite all this, the Muslims believe in Qadha-wal-Qadr, but Islam requires that one must find ways and means to keep away from such troubles and adversities whenever such things occur and one should try to minimize his/her or his/her family financial losses. Obviously there are apparent differences between Takaful and conventional insurance. All Muslims are advised to only participate in Takaful business in order to protect themselves and their families.

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