The Conventional Insurance System V Takaful Insurance System

1Conventional andIslamicInsurance Systems
The Conventional Insurance System versus the Islamic Insurance System
Conventional Insurance System
Most of people have fear and they do not like risk. Happiness is the main object
to the humanity. Making money is an important condition to get happiness and by
investing the money, people can make more money to satisfy their needs. Investing
money involves risk, which increase the return on this money. Generally, investors
prefer to increase the return and decrease the risk. Chinese and Babylonian traders in
the 3rd and 2nd millennium BC practiced one of the earliest methods of transferring or
distributing the risk. Chinese merchants preferred to move their goods by shipping them
on several boats to diversify the risk. Persia was the first country that attempted to insure
its people and made it official by registering the insuring process in governmental
notary offices. The Jewish rabbis claim that The Talmud deals with several aspects of
insuring goods. The Greeks and Romans introduced the origins of health and life
insurance c. 600 AD. In the 14thcentury, Italian merchants insured their exports and
imports, which were moved from or to Genoa coast. In the late 17th century, Edward
Lloyd opened a coffee house that became a popular meeting place for the ship owners,
merchants, and ships’ captains. Edward Lloyd 's coffee house became the meeting place
for parties wishing to insure cargoes and ships. Because of the great fire of London in
1680, Nicholas Barbon established England's first fire insurance company (Dorfman,
2007). The first insurance company in the United States was established by Benjamin
Franklin in 1732, he helped to popularize and make standard the practice of insurance.
In the 17th and 18th centuries, many companies in London (The center of world trade in
17 century) and U.S.A started to establish the rules and laws that standardized and
formulated the conventional insurance system.

The insurance company represents the 1st party of the insurance contract and
has a name of the insurer. The 2nd party of the contract represents the customer of the
insurance company and has a description of insured or a name of the policyholder or
policy owner. The insurance contract forces the insurer to protect the policyholder from
the risk of losses and compensate him for these losses. The policyholder should pay the
fees of the insurance policy or the premium to the insurer to get the right of the
compensation of the losses (Dorfman, 2007).
The process of the conventional insurance system is very simple and clear. The
insurance process begins when the policyholder pay the premium to the insurer. The
insurance policy represents the insurance contract and it has a maturity or expiry date.
The policy protects the policyholder from risk of the loss causes by the damage of the
insured property or person. The insurer or the insurance company receives the
premiums from the policyholders and invest them in profitable projects to generate
returns to the insurer. The greatest amounts of the returns go as an income to the owners
of the insurance company, which can be the stockholders of the insurance company.
The rest of the returns go as operating expenses to the insurance company to complete
the insurance arrangements, the policyholders do not have any right in these returns.
The insurer has to compensate the policyholder against any peril, that causes the loss
of the insured property or person during the maturity date of the insurance policy. Each
insurance policy has to identify clearly the types of the perils that cause the losses to
the policyholder. In addition, the amount and the value of the compensation that is right
to the policyholder should be clearly identified in the insurance policy. The
policyholder could trick and make tricky accidents that cause the losses of the insured
property and get the amount of the compensation from the insurer. This action will

repeal the insurance contract, gives the insurer the right of the premium, and exempt
him from the compensation's commitment.
The relationship between the risk and return is an inverse relationship, the
higher the risk the higher the return and vice versa. The insurance as a business is very
risky investment, which requires a very qualified and skilled staff to run the business.
In general, most of the insurance companies make huge amount of profits by managing
the risk of loss (Bodie, Kane, and Marcus, 2007). Most of the insurance businesses follow
the basic four insurance principles to limit the risk of loss. The first principle is the
similarity of a large group of items exposed to the same peril, which allows the
insurance companies to benefit from the law of the large numbers. This means, as the
number of similar items exposed to the same peril increase, the actual results become
more closely to the expected results. The second principle is the definite and accidental
loss, which allows the insurers to identify the time, place, and location of the peril that
result in the loss and just to cover the loss that is out of control of the beneficiary. The
third principle is the calculable loss and affordable premiums, which allows the insurers
to calculate the probability and the value of the loss and determines the value of the
premium according to size of the loss. The fourth principle is to limit the risk that cause
catastrophic losses, which means that t insurers avoid to issue insurance policy to the
events that requires huge compensations like earthquake policies, hurricanes policies
and wind policies (Bodie, Kane, and Marcus, 2007).
Insurance classification is very difficult and confusing. Most authors, professors
and the scientists face the problem of the insurance classification. In general, insurance
can be classified in different methods. Types of the Insurance according to the insurer
can be classified into two types. Public insurance that aims to help the citizens and
support the country. Private insurance that aims to make profits. Types of the insurance

according to the insurance policies and the risks and perils they cover can be classified
to many and unlimited kinds. Insurance policies and programs that are issued by and
supported by the government are four types. The social insurance policy covers the
perils of retirement, disability, unemployment, illness, and sickness. The agricultural
insurance policy covers the perils that threaten or destroy the agricultural crops. The
industrial insurance policy covers the perils that threaten the national plants and
factories. The banking insurance policy covers the financial perils that threaten the
banking industry. Insurance policies and programs that are issued the private insurance
companies are uncountable and unlimited. Private insurance policies can be classified
into several categories; In general, they can be classified to seven or eight types. Fire
insurance policies cover the losses of the real estate properties and human lives that are
caused by the fires. Marine insurance policies cover the losses of the mobile property;
these policies secure the properties that are moved by ships, trains, planes, and trucks.
Causality insurance policies insure against the accidents that injure the policyholder,
this type can be classified to different categories (Dorfman, 2007). Automobile
insurance policies insure against the car accidents that injure the policyholder and they
include financial perils, medical perils, and liability perils. Health insurance policies
insure against the perils that injure policyholder's health and they cover the policyholder
medical costs (Dorfman, 2007). Crime insurance policies insure against the perils that
are caused by criminals or thieves. Disability insurance policies insure against the perils
that affect the worker ability to work to generate an income like accidents of labors and
firing perils, these policies compensate the worker until he can work and generate
income again. Credit insurance policies insure against the perils that affect the borrower
ability to pay the loan payments to the lender. Legal liability insurance policies insure
against the perils that result legal commitments against the policyholder. Life insurance

policies insure against the perils that injure the life of the policyholder like death.
Terrorism insurance policies are the newest kind of the insurance policies and they
insure against the perils and losses which results from terrorist actions.
Standard line or life insurance companies and excess line or nonlife insurance
companies are the main two types of the insurance companies. Life insurance
companies issue life insurance policies, annuity insurance policies and pension
Types of the Insurance Companies and Policies
Government Insurance policies & Companies Private Insurance Policies & Companies
Social Insurance Policies
Agricultural Insurance Policies
Industrial Insurance Policies
Banking Insurance Policy
Fire Insurance Policies
Marine insurance policies
Causality Insurance Policies
Automobile Insurance Policies
Health Insurance Policies
Crime Insurance Policies
Disability insurance policies
Credit Insurance Policies
Legal Liability Insurance Policies
Life Insurance Policies
TerrorismInsurance Policies

insurance policies. It is very difficult and complicated to manage life insurance
companies because they have long-term commitments and their works are very risky.
Nonlife insurance companies issue different types of policies like property insurance
policies, causality insurance policies and the rest types of the private insurance policies.
Managing this kind of insurance companies is easier than to manage the life insurance
policies because they have short-term commitments and their works is not risky like
life insurance companies. Credibility and reputation are the most important two
elements for the insurance companies because without these two elements the insurance
companies cannot attract the customers to buy the insurance policies. The legislation in
the insurance field is difficult and insufficient. Many laws and legal acts were issued
by financial authorities to regulate and standardize the insurance industry. Many
insurance companies do not respect their commitments to the policyholders and most
of them do not continue in their works. The U.S.A and U.K have the most creditable
insurance companies in the world. American Insurance Group is the biggest insurance
company in the world, which had a total value of assets about $1 trillion in 2007. Today,
the global insurance industry grew by 12.3% and had a total value of assets $ 4.1 trillion.
The insurance industry is more developed in the developing countries than in the
developed countries (Bodie, Kane, and Marcus, 2007).
Insurance is useful for the economy and it has many benefits. One of the greatest
benefits which an insurance system rewards society is stability in families. Insurance
prevents from experiencing the great hardships caused by unexpected losses of property
or the premature death of the main income provider. Insurance is also very useful to
businesses. Insurance aids planning process because the planner knows will not mean
financial ruin, and the future of the business cannot destroy by a fire or the death of a
key person. Insurance aids credit transactions. Lenders are more willing to make

property or real estate loans if they know a disaster cannot destroy the financial security
behind their loan. Insurance is also useful for the economy because it functions as an
antimonopoly device. If no insurance system was available, only the largest businesses
could sustain losses and remain in operation. In general, all financiers recognize that
insurance availability tends to lower a firms cost of capital because both creditors and
investors would charge much more for the use of their money if it subjected to the risks
associated with natural disasters in addition to normal business risks (Dorfman, 2007).
Islamic Takaful Insurance System
Takaful insurance system or Islamic insurance system is the newest insurance
system in the world. It is difficult to talk about Takaful insurance because it is a new
and incomplete or imperfect insurance system. This insurance system has a short
history, not like the conventional insurance system. The Takaful industry is roughly 30
years young. Islam is an old religion that has a long history but no one during this
history discussed the permissibility or prohibition of the insurance because no Islamic
country adopted the insurance or dealt with the insurance officially (Kwon, 2007). Ibn
Abdin (1784-1836) was the first scholar in the Muslim World to discuss the meaning
and legal character of Insurance. Islamicity of insurance has been under discussion
since then. Mohammed Abduh was the first Islamic scholar during the decade that
started to formulate a new Islamic insurance system. In 1965, a group of Islamic
scholars of different mazahib (Islamic schools of thought) met and discussed the
reasons behind the prohibition or forbiddance of the insurance in Islam. In 1972,
meeting of the Islamic Studies Conference (ISC) considered eighty opinions on
insurance submitted by scholars worldwide, but adjourned without making final
recommendations, leaving the topic pending for further study. The first Takaful
company was established in 1979 and it was the Islamic Insurance Company of Sudan

(Kwon, 2007). Today, there are some 28 registered Takaful companies worldwide and
there are 10 more insurance companies' have adopted Takaful programs. Many
countries have adopted the Takaful insurance system like Malaysia, Bahrain, Kuwait,
the U.A.E, Egypt, Saudi Arabia, Pakistan, Australia and Lebanon, the U.K, the U.S.A,
Philippines, Sri Lanka and Singapore. Malaysia is the best country in the Takaful
insurance industry and it has a rate of growth 60% annually (Jones, 2008).
Islamic or Takaful insurance system was adopted as an alternative to the
conventional insurance system. All the Muslims around the world receive the fatwa
from the certified Islamic scholars. Islamic scholars have four sources for the legislation
in Islam. They are the Quran (Islamic holy book), Sunman or Hadith sharif (Prophet
Mohammed's instructions), Ijma'a (consensus of legal Islamic scholars and Qeyas
(justice reasoning in Islam). Sheikh Mustafa Zarqa and many of the legal Islamic
scholars agree that conventional insurance is prohibited in Islam because of four
reasons. These reasons are Al Riba (excess or interest on loans), Al Maisir (wagering,
speculation, gambling) , Al Gharar (uncertainty, deception and unclear terms) and
Investment of premiums by insurers into non-Shariah compliant securities . Insurance
is blamed for Gharar because, at the time of the contract, the insured are uncertain about
occurrence of indemnity, amount occurred in case of indemnity, and the timing of
indemnity. However, supporters of insurance argue that these matters are unknown only
at the individual level, while at collective level, they are scientifically determined by
statistical laws of large numbers, actuary, and probability. Insurance is blamed for
Maisir because the policyholders are seen to bet premiums on the condition that insurer
will make compensation payments (indemnity) of the happening of specific event. The
advocates of insurance argue that insurance is the contract of indemnity, which is
altogether different from gambling. A specific event must occur by the appointed time

and one of the parties must win or lose in gambling. In the case of insurance, the
specified event may or may not happen during the policy period. Riba refer transaction
involving unequal exchange of the same thing. Insurance is viewed as un equal
exchange of money in premiums and compensations. In fact, money paid in premiums
do not equal the money received in compensation. The insured or the policyholder
receives less or nothing when the policyholder withdraws the policy, defaults on
premium, does not experience peril, the insurance contract is declared void due to any
other reason. Compensation received from insurers may be is greater than the premiums
if a peril occurred. Here we have a riba because the insured receives compensation that
is higher than his premium. While in the other side, when there is no happening of
perils, the insured does not receive any compensation, which results a profit for the
insurer. The advocates of the insurance argue that there is no riba in insurance because
of several reasons. The money received in claim by the insured (compensation) depends
on the extent of financial loss incurred in consequence of a peril. Individuals engage in
riba transactions with the sole purpose of monetary gains, while the purpose of the
insurance policy is to protect, not to enhance the financial position of the insured.
Insurance is also essential part of banking and international trade transactions.
Insurance is illegal because the compensation is given to nominees, which is contrary
to the Islamic laws of inheritance.
Takaful insurance system is based on three principles. Mutual responsibility,
which means the feeling of responsibility towards one another. Mutual Co-operation,
which has the same meaning of this Hadith (Prophet Rule) "The relationship between
one believer and another (in a community) is like that of a building where one part of
the building strengthens the other parts." (Mutafaq 'alaihi). Mutual cooperation for the
protection of members in the event of loss.

There are five crucial elements that are very important and required to formulate
Takaful insurance. Ne'aa (intention) or utmost sincerity of Intention for knowingly
following the guidance and adhering to the rule and purposes of Takaful - cooperative
risk sharing and mutual assistance. Integration of Sharia conditions, namely risk sharing
under Ta'awuni (collaboration and cooperation) principles, coincidence of ownership,
participation in management by policyholders, avoidance of Riba and prohibited
investments, and inclusion of al Mudharaba. Presence of Moral Value and Ethics. No
Unlawful (illegal action or item) Element that contravenes Sharia (Islam rules).
Appointment of Sharia Advisory Council or Committee to oversee the development
and Islamic auditing of the Takaful operations.
Takaful is an alternative form of insurance. Consequently, many of the
principles and practices of insurance equally apply to Takaful. General Takafuls are
short-term contract for protection of potential material losses resulting from specified
catastrophes. Participants' installments are called tabaru (donation). Amount of Takaful
contributions varies, as in insurance, according to the value of property to be covered
under the general Takaful scheme. Company invests the tabaru funds, and the profits
accrued there from are allocated between the fund and the management on the basis of
mudaraba. Indemnity is paid out of the tabaru fund. Operational costs including
reinsurance costs and other reserves are also deducted from tabaru fund. If the fund
generates net surplus then, unlike insurance, surplus is shared between participants and
the company. In sum, in case of general insurance, there is no substantive difference
between tabaru and the premium from the insured point of view as the entire
contributions of the participants are treated tabaru, like premium in insurance
(Dirrheimer & Sohail, 2008). The contribution, like premium, depends on the value of
the property to be

covered. However, unlike insurance, Takaful participants are entitled to surplus in the
tabaru fund, if any. Islamic life insurance is organized in the name of family Takaful.
Premiums, unlike insurance, are determined by the participants themselves depending
on their financial strength. Installments paid by the participants are divided into
Takaful, also called tabaru. The proportion for tabaru fund, like insurance, is calculated
on actuarial basis, which varies according to the age and participation period of the
participants. Insurance benefits are paid from the tabaru fund. Participants pledge to
make additional contributions if Takaful fund proves insufficient. However, in reality,
companies prefer to carry such deficits forward till the Takaful fund enjoys surplus. In
the meanwhile, companies finance the deficits on the basis of interest free loans. The
actual operating expenses are charged from the Mudarabah accounts. Participants are
entitled to reimbursements upon maturity, withdrawal and, in some cases, upon
disablement. Upon the death of a participant, his profit shares are entitled to Takaful
benefits. The Takaful benefits are reimbursed according to the Islamic inheritance. If a
participant withdraws before the maturity of contract then money in the investment
account is paid as surrender benefits. In the case of the death of a participant, his heirs
are entitled to full value of the decreased participant's share in mudarabah investment
account plus money equal to all unpaid installments, due to be paid in future if he lived,
from the Takaful account. Participants cannot interfere with management activities as
the management assumes full authority. However, if a loss occurs due to disrespect of
modarabah conditions, the Takaful companies will bear those losses.
Takaful operations in the insurance primary markets can be broadly classified
into one of the three models: a mudarabah model, a wakala model, and a hybrid model.
With the mudarabah model, both the policyholder and the insurer share profits from
Takaful operations. With the wakala model, there is a complete separation between the

insurer's capital and the policyholder's fund and the insurer receives a fixed fee for
managing/investing the fund on the policyholders' behalf; that is, all profits from
Takaful operations less fixed fees for underwriting and investment services belong
exclusively to policyholders. Under the hybrid plan, the insurer may use a mudarabah
model for underwriting activates and a wakala model for investment activities. It is
worth a little that operating losses are born only by policyholders in all three models.
In all Takaful models, insurers use their capital (shareholders' fund) to provide interest-
free loans to cover deficiency in the policyholders' fund. Reasonably, all net gains and
losses from investing the insurer's capital are of the insurer's own.
On the other hand, some Malaysian professors argue against the previous
classification and they suggest another model of Takaful classification (Kwon, 2007).
This Malaysian classification provides three types of Takaful insurance models. Non-
Profit Model includes social-governmental owned enterprises and programs operated
on a non-profit basis. Al Mudharaba Model, whereby cooperative risk sharing occurs
among Participants yet the Takaful Operator shares also in any operating surplus as a
reward for its careful underwriting on behalf of Participants. Al Wakala Model,
whereby cooperative risk-sharing occurs among participants with a Takaful Operator
earns a fee for services (as a Wakeel or Agent) and does not participate or a share in
any underwriting results as these belong to Participants as Surplus or Deficit, operator
also charge a funds management fee (Dirrheimer & Sohail, 2008).
Takaful insurance system is one of the most dynamic areas of the boarder
market for Islamic financial services. As Moody's noted in a recent report, Takaful has
shown very impressive premium growth rates of about 20% in recent years. Total
Takaful has exceeded 2$ billion in 2005, and are expected to reach $7.5 billion by 2015.
The famous economist, Fitch, puts the total global Takaful contributions at about $2.6

billion (Jones, 2008). The Takaful insurance share in the insurance markets is vey small
compared with the world's insurance sector as a whole. But the Takaful insurance
industry will extend beyond its current size and there is substantial potential for growth
both in Muslim communities in the Middle East and Asia as well as in some more
mature markets (e.g., in France, Germany, UK, U.S.A, Canada, Spain, Russia,….etc),
which have significant Muslim minorities and significant desired customers (Ashton,
2008).

Note. The data on Takaful Potential Distribution are adopted from " Islamic Principle and Takaful
Insurance: Re-evaluation" by W. J. Kwon, 2007, Journal of Insurance Regulation, 26, pp. 53-81.
Retrieved from Ebsco database (2007-30856-681). http://info.euromoney.com.
Comparison between the Conventional Insurance and the Takaful Insurance
A comparison is made below to highlight the salient differences between
conventional insurance and Takaful insurance:
Conventional Insurers Takaful Operators
Sources of laws & regulations are set by
state and man-made.
Sources of laws are based upon Divine
revelations (Holy Quran and Hadith)
Profit-motive, maximizing returns to
shareholders.
Community well-being optimizing
operations for affordable risk protection
as well as fair profits for the operator.
Profits and/or Bonus units to be returned to
policyholders as determined by managers
and Board of insurer.
Takaful contract specifies in advance
how and when profit/surplus and/or
Bonus units will be distributed .
Initial capital supplied by shareholders.
Initial capital supplied by Rabb al Mal
(Agent) or paid in via premiums from
participants.
Separation of policyholder and insurer with
differing interests.
Coincidence of interests between
policyholder and operator as appointed
by participants.

Transfer of losses among insurance pools
and from policyholders to shareholders.
Losses retained within classes of
business written and sole obligation of
Participants.
Right of insurable interest is vested in the
Nominee absolutely in Life insurance.
Right of insurable interest is determined
by Islamic principles of Faraid
(inheritance).
Insured may elect cost or replacement cost
valuation and claim accordingly whether or
not they chose to rebuild property.
Insured may not "profit" from insurance
and entitled to compensation only for
repair or rebuild or replacement.
Agents and Brokers are typically
independent from insurer and paid a fee from
the premium charged to policyholders that is
not disclosed that is not disclosed.
Agents are employees of the Takaful
and any sales commission should be
disclosed.
Investment of premiums conducted by
insurer with no involvement by
policyholders.
Takaful contract specified under
principles of al Mudharabah how
premiums will be invested and how
results are shared. Under al Wakalah,
similar practice plus Participant can
direct his investments into a range of
unitized funds.
Insurer invests premiums consistent with
profit-motive with no moral guidelines;
hence co-existence of Al Riba and Al Maisir.
Takaful invests premiums in
accordance with Islamic values and
Shariah guidelines.
Dissolution - reserves and excess/surplus
belong to the shareholders.
Dissolution - reserves and
excess/surplus could be returned to
Participants, although consensus
opinion prefers donation to charity.
Taxes - subject to local, state, and federal
taxes.
Taxes - subject to local, state and
federal taxes (if any) plus obligated to
arrange annual tithe (Zakat) donations
to charity.
Benefits paid from general insurance account
owned by insurer.
Benefits paid from contributions(Al
tabarru) made by participants as mutual
indemnification.
Accounting consistent with GAAP and
prevailing statutory rules Auditing for
uniform application of accounting standards.
Accounting standards consistent with
national rules (with may be GAAP)
plus prevailing statutory rules. Auditing
same standards plus conformance with
Islamic rules; typically with Sharia
Advisory oversight.

Conclusion and Recommendation
Insurance, especially life insurance is an essential part of the social protection
needed for any society. It has its rightful place in Islam but years of misunderstanding
and misconception have created mental blocks against insurance in the Muslim culture.
I believe Takaful or Co-operative Insurance is the right way forward towards the
breakdown and removal of such mental blocks. This type of insurance has great deal to
offer in Muslim countries where the spread of insurance per person and per Syrian
pound of GDP can increase manifold if the system of Takaful is projected correctly and
understood properly. It can genuinely enlarge the insurance market in areas where
traditional insurance has not been able to grow, as it should have done. This is true of
personal lines, especially of life insurance or family Takaful.
In order to create the essential trust and confidence, which is needed to remove
the mental blocks just mentioned, the efforts to develop and manage Takaful business
must be genuine. Investors, entrepreneurs, and insurers have good opportunity to take
up the challenge of developing insurance business on Islamic principles. After all
Takaful is intrinsically in accordance with the indigenous consumer needs.
References
Ashton, M. (2008). Islamic market presents challenges. Journal of Fin Week. 17 (2),
64-65. Retrieved from Ebsco database (2008-34383-663).
Bodie, Z., Kane. A., & Marcus, A. (2007). Essentials of Investment. United States:

MCGraw-Hill.
Dirrheimer, M. J., & Sohail. J. (2008). The potential of Bancatakaful. Journal of
Financial services. 39 (2), 14-15. Retrieved from Ebsco database (2008-30059-281).
Dorfman, M. S. (2007). Introduction to risk management and insurance. Canada:
Pearson-Prentice Hall.
Insurance. (n.d). Retrieved June 2, 2009, from the WiKIPEDIA Wiki:
http://en.wikipedia.org/wiki/Insurance
Jones, M. (2008). The Next Step. Journal of Global Insurance. 109 (6), 145-148,
Retrieved from Ebsco database (2008-34928-004).
Kwon, W. J. (2007). Islamic Principle and Takaful Insurance: Re-evaluation. Journal
of Insurance Regulation. 26 (1), 53-81. Retrieved from Ebsco database (2007-30856-
681).
Takaful. (n.d). Retrived June 2, 2009, from the WIKIPEDIA Wiki:
http://en.wikipedia.org/wiki/Takaful

The Conventional Insurance System V Takaful Insurance System

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Similar to The Conventional Insurance System V Takaful Insurance System

Similar to The Conventional Insurance System V Takaful Insurance System (20)

The Conventional Insurance System V Takaful Insurance System