Principles of Islamic banking and finance/PIBF203/Takaful/Takaful and different models of Takaful

The Islamic alternative to conventional insurance is takaful which is although close to the concept of mutual insurance, has some distinct features. Takaful is governed by the principles of Shari’ah, where transactions involving Riba is prohibited. Riba is avoided in Takaful using contracts for profit shares rather than fixed interest and investment in Shari’ah compliant schemes.

Another essential difference is that conventional insurance by its conception is a risk-transfer mechanism. Takaful on the other hand does not entail a risk transfer mechanism, but rather a social function of mutual risk-sharing. The contract of Takaful is not a sale or an exchange, but is rather a membership contract to a common pool, of which every member is entitled to certain benefits but also exposed to some risks of loss. This also what makes Takaful system commercially more viable, as the remaining money after all claims does not belong to the shareholders, but rather to the participants and it should thus be given back. In addition, motivations of conventional and Islamic insurance companies are different; while conventional companies are directed by the search of profit. Takaful companies are directed by ethical considerations and work for the overall benefit of society and the environment. Regulation in Takaful is undertaken through Shari’ah supervisory bodies that ensure that all operations are conducted in line with the Shari’ah principles and fulfil Islamic objectives of social welfare.

Besides, the distribution of profits in case of conventional insurance is a managerial decision from the insurer company which is not necessarily favorable for all parties. While, in case of Takaful, distribution mechanism is defined in advance and the operator has no claims in underwriting surplus; this reduces the possibility of conflict between shareholders and policyholders. Finally, in case of dissolution of a conventional insurance company, reserves and surplus belong to the shareholders. While in case of dissolution of a Takaful operator, capital is distributed back to participants or donated to charity.

Takaful Agreements
Takaful agreements have specific characteristics and conditions that differentiate them from conventional insurance agreements. In fact, Takaful agreements cannot be sales contracts as such because of the element of uncertainty they contain; yet they should not include any uncertainties about main characteristics such as price, time and modes of payment. Takaful contracts should also include a subject matter upon which contracting parties mutually agree by an offer and an acceptance. And as any Shari’ah accepted operation, Takaful should avoid Riba, gambling and investing the fund in unlawful activities. In addition,

Takaful agreements should embody particular conditions that regard specialty, co-operative, mutuality, partnership, investment and management. The specialty condition validates that the Takaful Operator manages the fund according to Shari’ah principles and excludes prohibited activities such as Riba, Gharar and Maysir. Cooperative condition is about the participants paying contributions to a common fund to insure themselves against risk and help other members who suffer loss; they should pay a part of their contributions by way of Tabarru’. Mutual condition is linked to the principle of membership where the insurers and the insured are the same people managing and controlling their mutual security. Partnership condition guarantees the participants the right to share profits and losses; in fact any surplus goes back to the Takaful participants in proportion to their contributions; they also share eventual losses by contributing additional amounts if premium reserves were not sufficient to cover all the losses. The Takaful Operator shareholders receive their income in form of agency fees and a percentage from the common fund, plus profits on investment of capital and some particular funds. Investment condition specifies the scope of investment by the Takaful Operator which should be within the Shari'ah framework. Finally, management conditions represent the organization of Takaful Operator including the Shari’ah Supervisory Board which aspires at protecting participants’ interests.

Specifity
Takaful agreements have specific characteristics and conditions that differentiate them from conventional insurance agreements. In fact, Takaful agreements cannot be sales contracts as such because of the element of uncertainty they contain; yet they should not include any uncertainties about main characteristics such as price, time and modes of payment. Takaful contracts should also include a subject matter upon which contracting parties mutually agree by an offer and an acceptance. And as any Shari’ah accepted operation, Takaful should avoid Riba, gambling and investing the fund in unlawful activities. In addition, Takaful agreements should embody particular conditions that regard specialty, co-operative, mutuality, partnership, investment and management. The specialty condition validates that the Takaful Operator manages the fund according to Shari’ah principles and excludes prohibited activities such as Riba, Gharar and Maysir. Cooperative condition is about the participants paying contributions to a common fund to insure themselves against risk and help other members who suffer loss; they should pay a part of their contributions by way of Tabarru’. Mutual condition is linked to the principle of membership where the insurers and the insured are the same people managing and controlling their mutual security. Partnership condition guarantees the participants the right to share profits and losses; in fact any surplus goes back to the Takaful participants in proportion to their contributions; they also share eventual losses by contributing additional amounts if premium reserves were not sufficient to cover all the losses. The Takaful Operator shareholders receive their income in form of agency fees and a percentage from the common fund, plus profits on investment of capital and some particular funds. Investment condition specifies the scope of investment by the Takaful Operator which should be within the Shari'ah framework. Finally, management conditions represent the organization of Takaful Operator including the Shari’ah Supervisory Board which aspires at protecting participants’ interests.

Distribution of surplus
Under a Takaful scheme, if the fund generates net surplus at the end of the year then Takaful operator distributes it to the participants and the company based on the pre-agreed profit sharing ratio. A proportion the surplus may be upheld as a contingency to protect participants’ interests, while the remaining part is distributed among the policyholders. The surplus is calculated based on the total contributions paid by the participants to the Takaful Fund less the total value of claims paid to cover assured losses, less Takaful Operator’s management fees and expenses, less commission paid to the intermediaries and the change in the reserves. If the balance is negative and is insufficient to pay compensation and benefits, than the Takaful shareholders may provide a bridging interest-free loan to make-up the deficit that would be recovered from future surplus. The distribution mechanism is decided by the board of directors of a Takaful operator and should be approved by the Shari’ah board. In fact, at the end of each financial year the Takaful operator undertakes an evaluation to determine surplus or deficit. The surplus is distributed to participants only in the case of Family Takaful business that is associated with protection for livelihood and is prohibited for General Takaful that is associated with non-life forms of protection. The surplus may be calculated separately for each class of risk or on a combined basis. It could be distributes in cash, reduced from of future contributions, or credited to the participant’s investment fund. Moreover, depending on the Takaful Operator policy, surplus may not payable to participants whose paid claim exceeds the premium received plus share of surplus, or those who simply were paid a premium during the year of account. Finally, a proportion of the distributable surplus may be donated for charitable purposes after the consent of Takaful shareholders and participants.

Takaful Models
Different Takaful models have been developed to make the Takaful business compliant with Shariah and to satisfy the needs of people. Maybe the area of most concern to a newly takaful operator is which of these models is more acceptable from shariah point of view. This section introduces these models, describes their structures with the main distinctive features between them, and summarizes some of the the concerns raised against each model.

Mudaraba Model
As discussed in previous sessions, Mudarabah is defined as a kind of partnership, where one party provides funds (rab-ul-mal), and the other party offers his expertise and management (mudarib). In the insurance companies that are based on Mudaraba model the participants are the funds provider (rab-ul-mal), while the Takaful operator is the Mudarib.

Under this model, the Takaful operator will receive payment of the Takaful contributions which are considered as ra’s-ul-mal from Takaful participants. The Takaful company (operator) with the participant (policyholder) sign a Mudarabah contract and agree on all the details of how the surplus and investment profits will be shared between the two. Under this model, the initial investment is provided by the policyholders as donation to mutually help the participants who face an unfortunate situation. The Takaful company as Mudarib manages all the Takaful operations without providing any capital. If the operator make any profit, both the participants and the operator share the profit according to an agreed profit ratio. In case of loss, the participant should bear all the loss, except if the loss was due to mismanagement or negligence from the operator side. If Takaful funds was not enough to cover all the claims and expenses, then the Shariah Advisory Board and government regulatory body bound the Takaful operator to provide free - interest loan to cover the deficit in the Takaful fund. This loan will be paid back later from the participants profit share.

Shariah scholars have some concerns on the conceptual basis of the Mudarabah model. Their concerns are summarized in the following three points:

1. The first observation is that the Takaful contributions is considered as donation (tabrru'), in the same time the contract signed by the participant and the Takaful operator is a Mudarabah contract which is profit-loss sharing contract. These two concepts of donation and profit-loss sharing cannot be exist in the same contract.

2. It is also argued that, in this model, the surplus is considered as profit and it is distributed between the two parties, while the profit is not the same as surplus. This action makes the Takaful contract similar to the conventional insurance contract.

3. The requirement to provide free interest loan in case of a deficit contradicts the concept of Mudarabah which is a profit sharing contract and a the Mudarib cannot be a guarantor at the same time.

Wakala Model
The word Wakala is usually used to indicate “a representation of a person on behalf of another person in certain dispositions”. Because of the above mentioned issues found in Mudaraba model, many Islamic insurance companies moved to use Wakala model; more specifically, Middle Eastern companies. The idea here is that the Takaful operator works as Wakeel (agent) for the participants. The Takaful operator receives a fee for managing Takaful fund. Wakala fee is determined by the Shariah advisory board of the company, and it is usually between 20 to 35 % of the contributions. Similar to Mudaraba, the capital is provided by the participants,. After deducting the upfront Wakala fee, which is considered as donation (tabarrua’). Part of the tabarrua’ contributions is put into Participants’ Risk Account which is used to cover the claims, reserves, and re-Takaful costs. The other part is placed in the Participants’ Investment Account for saving and investments. After covering all the claims and all expenses, any underwriting or investment surplus is fully distributed among the participants according to their contributions. In case of deficit, the Takaful operator is obliged to provide interest free loan to make up for the deficit.

It was argued that the pure Wakala model has lack of incentives for the Takaful operator because he does not share in any profit generated from the investment which might discourage him to run the Takaful fund efficiently. Therefore, many Takaful companies applied Wakala model with incentive compensation, where the Wakala fee can be adjusted in case of underwriting or investment surplus. Despite, such practice became widely used; it is not acceptable by all Muslim scholars because of two reasons. Firstly, the operator by this way shares the profit from the underwriting surplus but does not share the losses, which is not fair. The second reason is related to sharing of underwriting surplus originating from donation. . To be clearer, the issue of donation contributions is still one of the problem which could not be solved by this model. It is still argued that under this model, the tabarru’ contribution remains as the property of the participant who has the right to receive the surplus back, which makes the tabarru’ contract conditional.

Wakala-Mudharaba Model
This model combines the aspects of both Murabaa and Wakala, by utilizing two funds: participants’ fund and shareholders’ fund. Wakala is applied when dealing with the underwriting activities, where the agent receives a fee for the work performed. The operator under this model share the profits with the participants in a manner similar to the mudaraba model. Therefore, the Takaful operator is entitled to receive agency fee for managing the fund as a Wakil, and a share of profit for managing the investment of the fund as Mudarib. This model seems to be more acceptable and favorable than the other models where it has been widely adopted in the Middle East and by many new established Takaful companies such as Abu Dhabi National Takaful Company. The reason after preferring this mixed model is that this model avoids the Shariah disputes which were mentioned before in Mudaraba model and at the same time it creates similar commercial results. It has the potential to combine the advantages of both models.

The issue in this type of model is whether it is acceptable to use more than one contract for one Takaful operation. It was also criticized because using this model allows the operator to take the best from one contract and avoid the other areas which are not benefiting in this contract by applying the second contract. For example, using Wakala contract to the Takaful operation allows the operator to receive a fee, and using Mudarabah contract allows the operator to share the profits with the participants which is not applicable in the Wakala contract. It is also not very likely that the Shariah Board of a takaful company, who are paid employees of the company, will be in a position to safeguard the interests of participants. There seems to be a clear case for government regulations to protect the interests of participants, theoretically the real owners of a Takaful company.

Wakala-Waqf Model
This model has been implemented first in Pakistan. It was introduced by the Sharia’ scholar Taqi Usmani. According to this model, shareholders of the Takaful company will initially make a donation to establish a separate legal entity called Waqf fund. The donation can be any reasonable amount which is determined by Shariah scholars. After creating the Waqf fund, the shareholders of the Takaful company lose their ownership rights on the Waqf fund. However, they have the right to manage and develop rules and regulations of the fund. The tabarru’ fund (premiums) paid from participants also becomes a part of the Waqf fund. That means the Waqf fund consists of donations from shareholders and participants. The combined amount will be invested in Sharia’ compliant investments and the returns will go back to the same fund and used for the benefit of the participants. Based on the Waqf principles, the donors (shareholders and participants) will lose their ownership rights on their monetary contributions. The monies will become the property of Waqf fund which can only be used for the benefit of all participants. The shareholders act as the owner of the Waqf fund who transfer the administration authority to the operator. The operator also acts as Mudarib when investing the Waqf fund, therefore, he has the right to receive part of the investment profit.

The shariah concerns, relating to the Wakala model are addressed by setting a separate Waqf entity in between the participants and the company, without disturbing the basic model. ,

This type of model is permissible and it is applied in Pakistan. However, there are still some criticisms and debates on the legitimacy Wakalah-Waqf model. Some of these issues are legal issues such as whether the application of this model will infringe the state’s law since most of the countries have their own Trustee laws. Other issues were discussed from Shariah point of view. For example, it is known that once Waqf is created, it goes to Allah to be utilized for the benefits of human beings. Therefore, when applying this model, the Waqf fund should not be owned by the Takaful company or policyholders. There are some questions arise here such as, what will happen to the Waqf fund if the Takaful operator is wound up due to certain reasons?