The Concept of Takaful

The action of taking precautionary measures or ‘ikhtiar’ against possible danger and its consequences are among the teachings of Islam.  As a concept, mutual insurance actually does not conflict with the teachings of Islam, as it is a method by which funds are pooled in order to help the needy.
However, handling risks through risk transfer on a contract of exchange, as in conventional insurance, is not in compliance with shariah principles according to scholars of shariah.  Although conventional insurance operates on the basis of a common pool, where the fortunate many will pay for the unfortunate few, its transaction today is based on a contract of exchange whereby the insured pays a premium in exchange for a promise by the insurer to pay financial compensation should a loss as defined in the policy occurs.  Through insurance, by paying certain amount of premium, the insured is able to transfer its risk to the insurance company.  The insured replaces uncertainty with certainty at the amount of premium paid.  This is the financial security provided by conventional insurance.   
Conventional mutual insurance is closer to the ideal of takaful, as the insureds transfer their risks to a pool that they own, and not to a proprietary insurance company. However, in addition to the avoidance of riba, other modifications need to be made to the juristic basis of insurance in order to achieve compliance with the shari’ah principles, notably the payment of contributions on the basis of Tabarru rather than premiums.
Transferring risk to another party in return for a premium is challenged because it brings at least three forbidden elements to the contract, namely gharar (uncertainty), maisir (speculation) and riba(usury).  Under Islamic law, any contract of exchange involving gharar (al bai’ al gharar)is prohibited.  The risk, defined as uncertainty of loss, is indeed a kind of gharar by nature.  Therefore, putting risk as the subject matter of a contract of exchange (insurance) is prohibited.  The insurance company that receives the premium and agrees to bear the risk is regarded as basing its fortune on good or bad luck of others, therefore falls under the definition of maisir (speculation).
Shariah scholars view insurance contracts as a transaction where money is being exchanged for money, as two parties to the contract are basically exchanging the premiums for claims, both in monetary terms.  Exchanging money for money itself is not a problem per se as long as there is no difference in amount or time involved.  However, under conventional insurance transactions, the premiums and claims being exchanged are different and take place at different times.  This brings about the problem of riba (usury). Furthermore, riba in the investment activities of the insurance companies is another element that makes conventional insurance unacceptable from a shariah perspective. 
It is furthermore important to understand that Islam is not inherently opposed to the idea of insurance, but most scholars are of the view that the conventional insurance contract does suffer from certain weaknesses in implementing the basic idea.  Thus, an alternative mechanism for dealing with risk has to be developed to replace prohibited conventional insurance. 
To bring insurance in line with Islamic principles, most shariah scholars suggest the concept of Takaful (solidarity, or guaranteeing one other).  Instead of transferring their risks to insurance companies, individuals or organisations that carry the same or similar risks make a collective commitment to help one other by pooling their risks.  Each participant will bring its risk into the pool and pay a certain amount commensurate to the risk.  The money payable to the pool is not a premium in the conventional sense, as it is not a price for transferring risk.  That money is a contribution or donation to the pool on the basis of tabarru’ (doing good deeds to one other) or takaful (guaranteeing one another).  For the sake of fairness, which is one of the most important fundamentals of Islam, the amount of contribution to the pool must represent the quality and the quantity of the risk introduced, so that no one commits dhulum (injustice) to others. 
Under takaful, the role of the insurance company has principally changed from the party who bears the risk to one who merely manages portfolios of risks.  Such companies are no longer entitled to earn all the amounts paid by the participants, as they take no underwriting risk and retain no obligation to pay claims.  In fact, the created pool now has the liability to pay for the claim and the insurance company works on remuneration paid by the pool.  Various operational models of takaful in the market differ fundamentally only in the manner in which the company is being remunerated.  However, the same basic idea of tabarru’ is adopted whatever operational model is being used.  All operational models are in absolute agreement on the relationship among the pool participants and differ only in defining the relationship between the pool (participants) and the company.
Takaful is not considered as a contract of exchange.  Instead of buying a promise based on an event that may or may not occur, takaful customers make a contribution to a common pool on the basis  of tabarru’ (donation), with the intention (niah) to participate in a mutual aid scheme.

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Adopted from Akoob, M. (2008). Reinsurance and Retakaful. In S. Archer, R. Karim, & V. Neinhaus, Takaful and Islamic Insurance: Concept and Regulatory Issues. Singapore: John Wiley & Sons (Pte) Ltd

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