A basic understanding of Takaful vs. Conventional insurance

We live in a highly sophisticated era of continuous financial innovations and product customization, which are targeted at specific consumer segments. One such product is Islamic banking, designed specifically for Muslims who have viewed conventional banking with increasing scepticism. Such was the scope of this sort of financing that many Muslims all over the world would not take on loans from conventional banks at all, preferring to either deprive themselves of the basic necessities of life, such as a car, or paying the entire amount in one go. Enter Islamic finance, conforming to the Islamic laws and differentiating itself from the conventional form with regards to two fundamental factors:

  1. Interest – Mentioned in the Quran as “Riba”, which means earning more than what you have loaned out. For example, Wafa loans out Rs. 100,000 to John. In Conventional finance, Wafa will charge a certain interest rate on her loan. However, in Islamic Finance she cannot do that. This is where Wafa and John need to engage in some sort of a partnership (called Mudarabah or Murabaha in Islamic finance) in order for both of them to benefit from the agreement
  2. Gambling – Mentioned in the Quran as “Gharrar”, which quite literally means excessive risk taking. Banks and other financial institutions are prohibited from taking on excessive amount of risk by investing in risky assets. One can argue that Shariah law is absolutely spot on with this component as conventional banks specifically trade in risky assets, looking for higher gains. The subprime mortgage crises of 2008 is a perfect example of excessive risk taking, resulting in losses worth billions of dollars

It is due to these and several other conditions mentioned in the Islamic law that has enabled Islamic scholars to devise the field of Islamic finance and distinguish it from the conventional one. This article focuses on one such area: Insurance; and compares both Islamic and conventional forms.

What is Conventional Insurance?

In a conventional insurance there are two parties involved, wherein one party the ‘insurer’ guarantees to take on risk and pay the other party the ‘insured,’ in case of an uncertain event. The risk shifts to the insurance company whereas the client pays the premium to get the coverage. The premiums are invested by the insurance firm in assets, which in turn generate money for the company. Please note that the premiums will be invested in any asset that generates a high return. These assets may include, extremely risky ones or products that are considered Haram in Islam. In the event that the firm makes more money than it has to pay out to the consumers in the form of claims, the excess cash goes to the shareholders of the firm.

The following diagram clarifies the above-mentioned process:

What is a Takaful?

The word Takaful is derived from an Arabic word called “Kafala” which means to take care of one’s needs. It is built on the concept of “Tawauun”, which quite literally means mutual cooperation for the good of all members of the society. That is, a group of people agree to contribute money in an insurance fund, which is then used to help any of the contributors in time of need. The money contributed by all the individuals is then invested in an asset which is deemed compliant by the Sharia.

Take the example of two individuals, Wafa and John, who would like to buy Takaful for their cars.

  1. They go to an Islamic bank and pay Rs. 15,000 to the firm for the purchase of Takaful
  2. This money is then added to the funds other Takaful buyers have provided
  3. Funds are then invested by the Takaful firm in certain assets that are permissible by Islamic law. Takaful firm cannot invest in shares of an alcohol firm or a casino
  4. If Wafa gets into an accident and ends up totalling her car, she will receive a predetermined amount from this fund
  5. The insurance firm in turn charges a certain fee or a percentage of the profits, for the services it provides to the buyers of Takaful

If towards the end of a particular period, Takaful firm makes more money than what is claimed by the consumers in the case of an unfortunate event, the remaining amount is distributed by the firm to the customers in the proportion of their initial contribution. For instance, if Rs. 15,000 represents 5% of the total investment, the excess cash will be distributed to the consumers in that proportion and will not go to the shareholders of the firm. Similarly, losses made by the Takaful firm are also shared in proportion to the initial investment of the consumers.

Takaful vs. Conventional car insurance – a numeric illustration

Suppose Akbar buys a car for Rs. 500,000. He now has to decide whether to go for conventional insurance or for Takaful. There are two scenarios:

Scenario 1:

Akbar opts for a conventional insurance at 2% premium per annum.

= 500,000 x 2%

= PKR 10,000

The 10,000rps premium is invested by the firm to earn a profit for the shareholders. Note that Akbar will not gain get any money if the insurance firm makes a profit. Akbar will have to pay a premium of Rs. 10,000 (or 2% of the book value of car) every year for unexpected car loss in the future. If a loss on car is incurred, then Akbar will receive the value of car after taking into account the depreciation overtime.

Scenario 2:

Suppose Akbar goes to an Islamic Bank (IB) to buy Takaful for his car. He will be asked to make contributions to the pool of funds at a given contribution rate, of say, 3%.

= 500,000 x 3%

= Rs. 15,000

These funds are invested to earn a profit which is ploughed back into the pool and distributed to the consumers if profits exceed the claims at the end of a particular period.

If Akbar ends up having an accident, he will be provided the necessary funds from the insurance pool to fix his car, similar to the service provided by the conventional insurance.

How is Takaful different from Conventional insurance?

The fundamental difference between the two is the establishment of a Shariah compliant structure which follows the above-mentioned principals of Islam. The following table summarizes some important differences:

Conclusion

Islamic banking is still not widely understood by a vast majority of individuals, who view this form of finance as being a substitute rather than a rival to the conventional form. One can argue that two main reasons that have given rise to this particular issue is a lack of proper education catered to the masses and unethical practices deployed by few banks who claim to be “Islamic.” Nevertheless, the acceptance rate has surely grown in Pakistan’s market in recent years with the growth in Islamic banks’ profit outpacing that of conventional banks’, during the first half of 2017. The main reason cited for this growth was an increase in awareness among consumers regarding Islamic products. Thus, as long as awareness grows, we can expect the sales of Islamic products to increase and prices should closely match those of conventional ones.