Why Takaful Is Needed in Islamic Finance - dummies

Why Takaful Is Needed in Islamic Finance

By Faleel Jamaldeen

Takaful is a new spectrum of insurance products that has emerged in recent decades. These products are based on principles, features, and structures that set them apart from conventional insurance.

Before takaful appeared on the market, many people in the Muslim community believed that trying to reduce risk went against Islam. Their perception was that because every worldly action comes from Allah’s will, people shouldn’t try to reduce or avoid the results of those actions.

Although Islam does prohibit attempting to avoid risk altogether, it doesn’t prohibit reducing risk.

The elements of uncertainty (gharar), gambling (maysir), and interest (riba) make conventional insurance products prohibited risk-sharing instruments for Muslims.

Uncertainty (gharar)

Conventional insurance is a contract between the insurer and the insured, but this contract doesn’t explicitly describe its outcome for either the insurer or the insured. And sharia doesn’t allow the sale of contracts that are based on uncertainty.

The conventional insurer has the assurance of receiving a premium each month but faces uncertainty regarding when and whether the insured will make a claim. Likewise, the insured may or may not incur losses or damages to prompt a claim.

In addition, when an insurance claim does occur, neither party knows in advance how much may be paid to the insured (or even whether the insurer will pay a cent). The insurer considers many variables when documenting an insurance claim, so predicting what the outcome may be for either party is impossible.

The bottom line: Islamic scholars agree that conventional insurance contracts are based on uncertainty, which means they aren’t sharia-compliant.

Gambling with premiums (maysir)

Going hand-in-hand with uncertainty is the fact that conventional insurance has characteristics of gambling. The conventional insurer receives huge amounts of money from the insured in the form of premium payments.

Will the insurer be able to hold onto that money? Or will some sort of disaster strike (tornado, wildfire, flood . . . pick a weather event) that results in the insurer paying out every dime of the premiums and then some?

When few claims are filed, the insurer wins (and the insured lose their premiums). When loads of claims are filed, the insured get some payback for their premiums (and the insurer may be in trouble).

Most Islamic scholars generally agree that conventional insurance products involve gambling and aren’t sharia-compliant.

Collecting interest (riba)

Another reason that Islamic law prohibits conventional insurance products is that their transactions involve interest. Interest generally comes into play in two ways:

  • Insurance companies need to make sure they can pay their customers’ potential future claims, so they rarely let the premiums they collect sit in a cash account. Instead, they invest the premiums in interest-bearing fixed income instruments such as conventional bonds.

  • If the insured files a substantial claim, she may receive an amount from the insurer that totals more than the premiums she has paid. Most Islamic scholars consider any excess amount paid by a conventional insurer to be interest.

  • Keep in mind that someone who purchases a takaful product can also receive an amount that exceeds the total contributions she pays in. In that case, the excess amount is not considered interest.

    The difference is not just semantics; the difference lies in the structure of a takaful fund and the transfer of risk (which is quite distinct from a conventional insurance product).