Understanding Insurance

14. Conventional Insurance vs Islamic Insurance: Relationship between Parties

We have ended the previous article How to Make Insurance in line with Shariah? with the statement that takaful or Islamic insurance that we know today is the result of a modification to conventional insurance. The modification was carried out by removing the concept of risk transfer which is problematic part from Shariah point of view and replacing it with the concept of risk sharing.

The statement above might give an impression that the process of removing and attaching certain element is a simple stuff. It might sound that simple, but in fact it is actually very fundamental and entails many significant consequences for the entire Islamic insurance system. We will discuss this consequences in this and several following articles. The discussion should be able to refute the misunderstanding that seems to underestimate Islamic insurance with the statement that it is merely a conventional insurance which Basmalah added on the policy preambule.

Before diving into more details, let’s refresh our memory on the difference between risk transfer and risk sharing. Risk transfer means the risk is transferred to insurance companies that charge a premium for the service. While risk sharing means the risk owners bear the risk collectively.

Relationship between the parties

Relationship between the parties in conventional insurance

The first consequence of the shift from risk transfer to risk sharing lies on legal relationship between the parties involved. In conventional insurance, it is clear that the insured and the insurer are bound by a contract of sale or exchange. The role of each is also very clear, namely as a buyer and seller. This is the only contract that exist in the transaction. The insurance company certainly has a similar contract with the other insureds.

However, it is important to note that there is no binding contractual legal relationship between one insured and another.

We often hear the argument that even in conventional insurance mutual responsibility among risk owners does exist and it is facilitated by the insurance company. The proof is that conventional insurance works using the pool of funds and the law of large numbers. It’s just that the pool of fund is owned by insurance companies. What is your opinion?

In my opinion, conventional insurance does look mechanically the same as Islamic insurance because both work on the law of large numbers and pooling of funds. However, the absence of contracts or agreements between fellow insureds breaks the argument that mutual responsibility exists in conventional insurance. The only contract or agreement exists is between the insured and the insurer (see picture below, left). That is it. This explains the genuine motivation in buying insurance is simply to transfer risk to the insurance company, not to help fellow risk owners.

Differences in legal relations between the parties to conventional insurance and Islamic insurance

Relationship between the parties in Islamic insurance

Under Islamic insurance concept, first of all, a risk owner or participant has an agreement or contract with all other participants that they agree to bear one another risks or help one another over losses that befall anyone among them. As seen in the picture above (right), each participant of Islamic insurance essentially has an agreement with each and every other participants by which they reciprocally promise to help each other or bear one another risks. This is the first contract under Islamic insurance structure.

Of course, in reality, it is not practical for every participant to sign a contract with each and every other participant. How to execute this contract efficiently then? This is one of the roles played by Islamic insurance companies, namely representing other participants who have become members. So, when a new participant is joining the Islamic insurance scheme, all he has to do is to make mutual agreements with other participants through the Islamic insurance company acting on behalf of the other participants.

The second contract is an agreement between each participant and the Islamic insurance company. By this agreement, the participant is basically appointing the company as the manager of the risk sharing scheme among the participants. It is through this contract that the Islamic insurance company receives a mandate from participants to carry out all aspects of risk portfolio management including marketing, underwriting, reinsurance, claim settlement, contribution collection, claim payment and so on.

So, it is not totally wrong if someone says that Islamic insurance set up is more complicated than conventional one. From the structure of the agreement alone, as described above, sharia insurance is more complex indeed. Having said that, it is very important to ascertain how this complexity can be clearly and firmly reflected in the contract (policy). No less important is how to ensure the customer understands the structure and its consequences. Only with high level of transparency that such mutual agreement and understanding can be reached. It is clear that merely adding Basmalah to the head of the policy does not make the contract Shariah compliant. There are many details that must be harmonized within the body of the contract.

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