Chapter 8

Islamic Insurance (Takaful)

Learning Objectives

1 Understand the meaning and basic concepts of takaful as an

alternative to conventional insurance with an insight into its historical
development.

2 Describe the innovative Sharī‘ah-approved models and structures of

takaful.

3 Describe the main takaful products and their expansion into the
global insurance market.

4 Analyze the process of determining and allocating surplus or deficit

as proposed by AAOIFI.

5 Explain the relevance of reinsurance and retakaful in the modern

practice of takaful business.

Chapter Overview
Takaful, which is a major component of the Islamic finance industry, constitutes an
emerging market in the global economy. It is the Islamic alternative to conventional
insurance. Takaful has a number of models that are patterned after some key
principles of Islamic law regarding the rights, duties, and responsibilities of people
towards others. The significance of takaful for the stability of the Islamic finance
industry is beyond doubt.

This chapter presents takaful as a mutual or cooperative form of insurance rather

than just personal gains and discusses its basic concepts, models, and structure.
It further examines underwriting surplus and technical provisions. Reinsurance and
retakaful are examined through a comparative study with particular reference to the
emergence of retakaful. Bear in mind that retakaful is the Islamic alternative to the
conventional practice of reinsurance. Meanwhile, aspects of Sharī‘ah governance
and compliance in takaful are also examined, with particular reference to the
Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)
guidelines and the Islamic Financial Services Board (IFSB) principles. In order to
 complete the total framework of Islamic finance, takaful should be incorporated
to mitigate inevitable risks and losses. Takaful is the third component of the Islamic
finance industry, the other two being Islamic banking and Islamic capital markets.

A. Basic Concepts of Takaful

Definition of Takaful
● The term takaful is an Arabic word that originates from the verb kafala - to guarantee, to
secure, or to be responsible for others.
● Takaful is a mutual undertaking based on collective assurance and cooperation.
● Takaful is based on three basic concepts of mutuality: mutual help, mutual responsibility, and
mutual protection from losses (See Figure 8.1).
● The takaful system of insurance is one in which members contribute their financial resources to
a common pool based on the principles of ta’awun (mutual assistance) and tabarru’ (donation)
and the group undertakes to share the mutual risk.
● Generally, takaful is premised on the concept of tabarru’, which encompasses mutual assistance
and mutual social security among the members.
● Since takaful is a collective undertaking whereby members agree to guarantee one another
against unexpected loss or damage (based on the common pool of resources), mitigation of risk,
similarly its allowance in other Islamic partnership contracts, is permissible.

The need to introduce certain risk management processes began during the time of the Prophet. The
exchange (below) between the Prophet and a Bedouin illustrates a better understanding of active
engagement (followed by trust in Allah) in commercial transactions.

“One day Prophet Muhammad noticed a Bedouin leaving his camel without tying it and
he asked the Bedouin: ‘Why don’t you tie down your camel?’ The Bedouin answered: ‘I
put my trust in Allah.’ The Prophet then said: ‘Tie your camel first, then put your trust in
Allah’.”

● In takaful, unlike conventional insurance schemes (prohibited by Islamic law) based on a buyer-
seller arrangement, the cooperative insurance scheme is adopted when there is a structured
arrangement among certain people who mutually contribute a fixed amount of money to a
common pool of funds from which compensation is paid to any member who suffers losses.
● All Islamic financial institutions need to undertake certain takaful schemes to effectively
manage unpremeditated risks and losses arising from the commercial activities.
● As with all Islamic financial procedures, it is mandatory that all takaful models are designed in
accordance with all Sharī‘ah mandates.

The Main Features of Takaful

The three main features of Takaful are cooperative risk-sharing, clear financial segregation, and
Sharī‘ah-compliance in underwriting policies and investment strategies.
Cooperative risk-sharing
● A move to eliminate riba and gharar elements in takaful, cooperative risk-sharing was designed
as the means of donation (social responsibility, solidarity, and the innate need to care for others
are among the characteristics of such a cooperative move).
● Although policyholders pay some sort of premium, they are considered as donations to the
common cause to assist those members who suffer any loss.

Clear financial segregation

● There is a clear segregation between the participants and the operator (or wakil).
● Islamic insurance companies are not considered as insurers, but rather as operators in charge of
managing the insurance portfolio and investing the insurance contributions (on behalf of the
participants).
● Unlike in the takaful scheme, conventional insurance companies are profit-making entities that
agrees to bear the financial burden and losses of its policyholders.

Sharī‘ah-compliant policies and strategies

● Policies that are used to determine the extent of risk-taking of insurance operators against the
payment of certain premiums are known as underwriting policies.
● The amount of liability to be accepted and the extent of coverage fall under the underwriting
policies.
● Both the process and the end products of the underwriting and investment mechanisms of
takaful companies must be Sharī‘ah-compliant.
● Takaful operators are required to put in place a standard Sharī‘ah governance system to ensure
such compliance with the Sharī‘ah.

As shown in Box 8.1, the core principles of takaful as outlined in the IFSB Guiding Principles for
Takaful are tabarru’ (donation) commitment, ta’awun (mutual assistance), and prohibition of
riba, gharar, and maysir.

Major Difference Between Takaful and Conventional Insurance

The major differences between the takaful and conventional insurance frameworks are parties to the
contract, payment of premiums, and investment.

Box 8.1: Takaful Core Principles

Although takaful operators adopt different models depending on how their undertakings are
structured, the general concept remains the same, as it is based on the three core principles of
takaful.

1. Tabarru’ (donation/contribution) commitment

Tabarru’ is an Islamic concept of donation or charitable contribution that is primarily targeted at
assisting others. The objective of tabarru’ is to donate for the benefit of others under a contractual
scheme. It is the first building block in the structuring of a takaful transaction. Each takaful participant
makes this commitment to fulfill the objective of mutual assistance through premiums.

2. Ta’awun or mutual assistance

The second core principle of takaful is mutual assistance, which is the main reason for the initial
tabarru’ commitment. Having put together enough resources as part of the tabarru’ commitment, the
participants agree to mutually indemnify one another in the event of losses arising from an
unforeseen event. Such mutual assistance is seen as an important aspect of the daily lives of Muslims,
which is adapted to the needs of entrepreneurs, investors, and merchants in the Islamic finance
industry. While the Islamic form of cooperative or mutual assistance is not averse to profit-making,
the primary objective of the scheme is to assist one another based on the concept of ta’awun as
chiefly documented in the Qur’an and Sunnah.

3. Prohibition of riba (usury), gharar (excessive risk or uncertainty) and maysir (gambling or
speculation)
As in all other commercial transactions, there is a general prohibition on riba, gharar, and maysir in
takaful undertakings. This is because, in most cases, the pool of funds contributed by participants is
invested in profitable business to increase the asset base of the takaful scheme. The takaful operator,
who technically manages and oversees the takaful funds, must consider the mandatory prohibitions in
commercial transactions when making investment decisions.

Parties to the Contract

● In conventional insurance, there are two main parties, the insurance company and the insured
party (who has nothing to do with other insured parties in terms of guaranteeing one another
against any loss).
● In the takaful scheme, the participants mutually insure one another against any loss, and the
takaful operator is merely a fund administrator.

Payment of Premiums
● The insured party in a conventional insurance scheme pays regular instalments, called
premiums, in return for insurance cover.
● The insurance company guarantees the payment of compensation in the event that the
insurance contract occurs.
● In takaful, premiums are not paid as regular instalments, but instead as a donation from
participants into the common fund, to guarantee the receipt of compensation (for other
participants) in the event that the insured-for occurrence happens.
● The participants remain the owners of the “premiums” even though they have donated them
into a pool of funds to indemnify any member of the group.

Investment of Insurance Funds

● Takaful funds, unlike those of conventional insurance companies, are invested solely in Sharī‘ah-
compliant products and companies.
● Profits from such investments are distributed on the basis of pre-agreed ratios (note: model of
takaful adopted by the stakeholders determines the profit distribution as well)
 as the remuneration of the takaful operator in the underlying takaful contract.

Historical Development of Takaful

● Different practices during the pre-Islamic era that were not contrary to the general spirit of the
Sharī‘ah were streamlined by the Prophet and adapted into the law.
● The idea of mutual assistance is innate and common among the early Arabs; accordingly, Arab
traders had a common practice of insurance protection (upheld by the Prophet based on Islamic
ideals with the advent of Islam).
● Shared responsibility (aqilah) between the Muslims of Mecca and Medina during the incident of
the Prophet’s migration is a classical precedent of takaful.

Table 8.1: Specific Differences between Takaful and Conventional Insurance

Takaful Conventional Insurance

A combination of tabarru’ contract and agency Contract of exchange (sale and purchase) between
and/or profit-sharing contract insurer and insured
Participant’s duty to make contributions to the Policyholder’s duty to pay premium to the insurer
scheme and expected to share the surplus mutually
Takaful operator earns a fee for rendering the Insurance company makes a profit when there is an
service of managing the takaful fund and from the underwriting surplus
mudarabah profit-sharing scheme as mudarib
Countervalue (‘iwad) is effort and/orundertaking of No clear valid countervalue. Source of profit is
risk anticipating (hoping) that the uncertain future will
be in the insurer’s favor (that total premiums will
exceed total claims)
Takaful operator acts as administrator of takaful Insurer is liable to pay the benefits as promised
fund and pays benefits from it. If the fund is from insurance funds or/and shareholder funds
insufficient, operator must provide an interest-free
loan to rectify the deficiency
Indemnification component is based on mutual Indemnification component is a commercial
contribution, reciprocal donation (tabarru’) relationship between insurance company and the
insured
There is no insurer-insured relationship between There is a clear insurer–insured relationship
takaful operator and participants. Participants act
as both the insured and the insurer simultaneously
Takaful funds must be invested in There is no restriction in investment of
Sharī‘ah-compliant instruments funds

Figure 8.2 gives a brief timeline of the development of takaful in the modern Islamic finance industry
from 1977 to date and how it is expected to grow in the next few years.

● Takaful dates back to 1979 when the Islamic Insurance Company was established in Sudan,
where takaful was offered based on the cooperative insurance model.
 ● Over the last several decades, not only have several companies begun offering takaful but
contemporary Islamic scholars have issued numerous resolutions on the permissibility of takaful
as cooperative insurance.
● Besides the establishment of takaful insurance companies, multinational insurance companies
have opened takaful subsidiaries, allowing for takaful products to spread all across the globe.
● With growth estimates of 10-20 percent a year for the takaful industry, the global takaful
premium could reach an approximated US$25 billion in 2015.

Global Islamic Finance: Current Position of Takaful in the World

Though the takaful aspect of the global Islamic finance industry has seen slow growth in terms of
expansion compared to other Islamic banking products, it remains a promising component of the
sector (from available data, the takafulindustry is currently concentrated in South-East Asia and the
Middle Eastern and North African (MENA) countries). The industry has seen a surge in growth since
the global financial meltdown as a result of the paradigm shift on the part of larger international
takaful companies such as the American International Group (AIG), which established AIG Takaful
Enaya, headquartered in Bahrain. In order for continued growth, takaful operators need to diversify
their products and introduce new areas such as medical insurance and introduce frameworks to
address complex risk issues. Partnering with international giants in Europe and America will further
expand the market rather than concentrating on the MENA and South-East Asian countries. Though
the industry has great potential for expansion, there is a need to restructure takaful products to be
conventionally viable and competitive without violating any Islamic law precepts to be able to
penetrate markets in Europe and America. The focus of the industry will now be turned towards
the exploration of new international growth markets for takaful.

B. Models of Takaful
Although there are different types of takaful models, some based on one Islamic product while others
are hybrids, the main two parties involved in the implementation of the takaful system are the takaful
operator and the participants.

Takaful operator- the party who manages and administers the takaful fund. The party is neither the
owner of the funds nor the owner of the company but the trustee of the takaful funds. It should be
noted that the agents of the takaful operation, who are entitled only to agreed upon fees or
commissions, are considered as part and parcel of the operator.

Participants- the owners of the takaful fund. They are the investors or fund contributors in whatever
model is adopted by the manager of the takaful fund.

The Mudarabah Model

● The mudarabah model of takaful based on the Islamic finance product known as mudarabah ,
and is commonly used in trust financing (see Figure 8.3 for an example of a mudarabah model of
takaful).
 ● The takaful operator is the entrepreneur (mudarib) appointed by the participants, who act as
the financiers, investors, or fund contributors (rabb al-mal).
● The funds contributed by the participants into the common pool of funds, which is used for
underwriting purposes, is known as the participants’ risk fund (PRF).
● The fund used for investment activities on the other hand, is known as the participants’
investment fund (PIF).
● Both funds are jointly owned by the participants.
● When the PIF is invested in Sharī‘ah-compliant business, the profit is shared between the takaful
operator and the participants based on a pre-agreed ratio.
● Since the takaful undertaking involves both insurance coverage and investment, the takaful
operator is considered a business partner of the participants when it comes to the investor-
entrepreneur relationship under the mudarabah contract.
● The profit-and-loss sharing principle is based on the classical mudarabah contract.
● The takaful operator is remunerated from the underwriting surplus as agreed upon by the
parties in the underlying takaful contract.

The Wakalah Model

● The wakalah model, the most widely used takaful model, is based on the Islamic finance
product known as wakalah (agency) (outlined in Figure 8.4).
● This model is based on the contract of agency between the takaful participants and the takaful
operator, where the former are the real owners of the fund while the latter acts as an agent.
● The takaful operator merely acts as an agent in the management and administration of the fund
(owned by the participants) for a contractual fee clearly specified and agreed upon by the
parties.
● Any surplus realized from the investment of the participants’ funds will only go to the
participants.

The example of the wakalah model of takaful outlined in Figure 8.4 has the following steps:

1 Participants pay contributions into a common fund.

2 The common fund is delegated to the takaful operator as an agent for a mutually agreed fee,
which also includes management expenses.
3 The takaful operator invests the PIF in Sharī‘ah-compliant business.
4 Claims and underwriting surpluses can be made on the PRF.
5 Any end-of-year surplus is paid to the participants.
6 A performance fee may be paid to the takaful operator for prudent management of the fund.

● This principal–agent relationship is strictly enforced and built into the underlying contract to
establish the rights and duties of each of the parties to the contract. FSB-8 suggests that the
agency fee should cover the total sum of the following costs: (1) management expenses, (2)
distribution costs, including intermediaries’ remuneration, and (3) a margin of operational profit
to the takaful operator.
 ● The takaful operator does not share in any risk borne in the investment or management of the
takaful fund.
● In addition to the normal agency fee, there can be an additional performance-related fee, where
some incentives (good practice in the industry to promote competitiveness and prudent takaful
fund management) are given for good management and governance related to the underwriting
output.

Hybrid Wakalah-Mudarabah Model

● Under this hybrid model of takaful, the wakalah model is employed for the underwriting while
the mudarabah model is used for the investment activities.
● The takaful operator is entitled to an agency fee or a mutually predetermined commission in
their role as a wakil or agent who manages the takaful funds.
● Additionally, they are entitled to a share in the profits realized for managing the investment
activities of the fund in their role as an entrepreneur.
● The duality of this model makes it particularly unique and is the reason why it is becoming more
popular, as many scholars have adjudged it to be the most suitable and mutually beneficial
model for all the parties concerned.
● The takaful operator’s sources of income are greater in this model, being the agency fee,
incentive fee, and the profit share from the investment of the funds.

The steps in the hybrid model, as illustrated in Figure 8.5, are:

1 The participants appoint the takaful operator as an agent, for a mutually agreed fee.
2 The takaful contribution is divided into the PIF and PRF.
3 The investment profit from the PIF, based on the mudarabah model, is shared between
the participants and the takaful operator.
4 The investment profit from PRF is added to the PRF account, which is used for
underwriting activities.
5 Any profits and underwriting surplus may be distributed to the participants.

Waqf-Wakalah-Mudarabah (Ultra-Hybrid) Model

● Introduced by renowned Pakistani Sharī‘ah scholar Muhammad Taqi Usmani, this model is a
hybrid of the wakalah and waqf (charitable endowment) models with an additional mudarabah
element (see Figure 8.6).
● This model has been adopted by takaful companies in South Africa and some other countries,
including Swiss.
● In this model, the takaful companies’ shareholders make donations to a common pool
of funds (which are invested in Sharī‘ah compliant business activities) that has been established
as a waqf.
 ● The returns (not the principal, which is used for the continued maintenance of the waqf fund)
from the investments plus any contributory funds (tabarru’) in the Participants’ Special Account
(PSA) are used for the benefit of the participants.

The steps in the hybrid model are summarized in Figure 8.6. They are:

1 Participants pay contributions as waqf into the common pool of funds for mutual
indemnification.
2 Participants enter into an agency contract with the takaful operator, who is paid a fixed
agency fee.
3 The takaful operator invests the funds in Sharī‘ah-compliant business.
4 The profits accruing from the investment are added to the tabarru’ funds in the PSA and
used to underwrite the risks of the participants.

Table 8.3: Key Elements and Differences of the Takaful Models

Mudarabah Wakalah Hybrid Ultra-hybrid

model model model model

Contracts Mudarabah only Wakalah only Wakalah and Wakalah,

used mudarabah mudarabah and
waqf
Investment Investment in Savings and Investment in Investment in
strategy Sharī‘ah-compliant investment in Sharī‘ah-compliant Sharī‘ah-compliant
assets Sharī‘ah-compliant assets assets
assets
Operator’s Invests the funds Administers Administers Administers the
responsib- and manages the the takaful the takaful takaful
ility whole takaful undertaking undertaking undertaking,
undertaking and oversees the and oversees the oversees the
investment of the investment of the investment of the
funds funds funds, and manages
the waqf fund
Initial Participants’ Participants’ Participants’ Participants’
capital premiums premiums premiums premiums and
used charitable donations
(waqf)
Benefits Mutual guarantee Mutual guarantee Mutual guarantee Mutual guarantee
for the participants. against any risk for for the for the participants.
Profit to be shared the participants participants. Operator and
between operator and end-of-year Profit to be shared participants share
and participants. surplus. Agency fee between operator profit from the
Surplus to be for the operator. and participants. investment of
distributed to Surplus to be cash waqf funds.
 participants. distributed to Returns from waqf
participants. investment of the
participants to be
added to PRF.

C. Main Takaful Products?

General Takaful
● Also, called composite takaful, a general takaful contract provides short-term, but renewable
takaful cover where the assets and other proprietary belongings of participants are protected
from foreseeable material loss or any form of damage.
● The takaful participants pay certain specified contributions while the takaful operator
undertakes to manage the risk through the administration of the underwriting activities.
● A general takaful fund is established (from the participants’ contributions) and used for
Sharī‘ah-compliant investments.
● The investment’s profits are returned to the fund for the purpose of indemnification.
● General takaful is divided into two categories, motor and non-motor takaful.

Challenge: Name three examples of general takaful aside from the examples given in this chapter.

Family Takaful
● Family takaful is the Sharī‘ah alternative to life insurance.
● This type of policy, unlike general takaful policies, is usually offered as a long-term policy cover
that may span between 10 and 30 years.

Islamic Finance in Practice: HSBC Amanah Homeowner Takaful (Source:

www.hsbcamanah.com.my/1/2/amanah/personal/amanah-protection/homeowner-takaful)

As part of the Islamic products offered by HSBC Amanah, the Homeowner Takaful was introduced
specifically to provide Islamic insurance coverage or its Home Financing- customers, HSBC Amanah is
regarded as an intermediary in the scheme. However, any claims and liabilities are handled directly by
HSBC Amanah Takaful for consideration and onward processing. An amount of up to 10.5 percent is
paid as a commission to HSBC Amanah for the service rendered. In order to protect against loss or
damage to one’s house, HSBC Amanah introduced this model to cover the following disasters:

○ fire/lightning/thunderbolt/subterranean fire
○ explosion/aircraft damage/impact damage by
○ third-party, road vehicles, or animals
○ burst or overflowing domestic water tanks,apparatus, or pipes
○ theft with violent or forcible entry or exit
○ hurricane/cyclone/typhoon/windstorm/
○ earthquake/volcanic eruption/flood
 ○ riot /strike/malicious damage
○ loss of rent
○ public liability

All these liabilities relate to the house that is covered by the policy. The basic premium costs as little
as US$3.5 for cover of US$3,225 under the scheme. The total amount of coverage is calculated in
accordance with the need and circumstances of each person and this is usually contained in the
takaful contract.

The three types of family takaful are ordinary collaboration, collaboration with savings, and
collaboration based on specific groups.

Ordinary Collaboration
○ In this type of family takaful, the concept of tabarru’ is adopted whereby participants
mutually agree to contribute to a common pool of funds through donations.
○ Their premiums are used for underwriting activities in the event of any mishap or
disaster on the part of any of the groups’ members.

Collaboration with Savings

○ This type of coverage includes both collaboration through mutual indemnification and
also acts as a savings account.
○ Partners contribute through donations into a common pool of funds from which
underwriting activities are carried out, while the other fund pool constitutes individual
participants’ savings (held for a fixed period of time, after which they may be
withdrawn).

Collaboration based on specific groups

○ This type of family plan is usually structured in a manner that reflects communal, ethic,
or organizational needs.
○ Participants of this type of plan can come from the same community, district, or social
group (membership is limited to those who come from the same community or group).
○ Their contributions may be made jointly or separately by the organization and the
participants.

Islamic FInance in the News: Islamic Insurance: A global market ripe for growth (Source: Andrea
Felsted, “Islamic Insurance: A global market ripe for growth”, Financial Times, September 22, 2011.).

Over the past several years, the Islamic insurance industry (which still only represents 1 percent of the
global insurance market) has witnessed strong growth in spite of global economic troubles. Ernst &
Young says global takaful contributions totalled US$9.15bn in 2010, and are on course to reach
US$12bn at the end of this year (and could reach US$25bn by the end of 2015). According to Ernst &
Young, Saudi Arabia, with takaful contributions totalling $3.86bn in 2009, Malaysia with $1.15bn, and
the United Arab Emirates with $640m, was the top three markets. Many analysts believe however,
 that for the takaful industry to reach its full potential, it must make inroads into Europe and the U.S.,
and into conventional insurance products,

PwC’s Mr. Khan says the tipping-point for takaful will come when it also appeals to non-Muslims.
[Takaful] is ethical insurance, and that is the market to go for. The market in the U.S., in western
countries isn’t just Muslims, and shouldn’t be restricted to Muslims, he says. Despite other obstacles,
including compliance and regulatory issues, analysts remain optimistic about the potential growth
opportunities within the takaful industry.

D. Underwriting Surplus and Technical Provisions?

As the takaful industry continues to develop, there is an increasing need to understand the appropriate
manner to determine and allocate surplus (from premiums) in a way that is Sharī‘ah-compliant. This is
especially significant as Islamic insurance companies become more profit-oriented in order to better
compete with their conventional counterparts.

Underwriting Surplus
● According to AAOIFI, “insurance or underwriting surplus is the excess of the total premium
contributions paid by policyholders during the financial period over the total indemnities paid in
respect of claims incurred during the period, net of reinsurance and after deducting expenses
and changes in technical provisions.”
● Underwriting surpluses are important for several reasons, as in most cases participants make
donations to the common pool for mutual indemnification.
● To regulate this, the underwriting surplus (all indemnities paid for deserving claims, the
retakaful policy and changes in technical provisions must be deducted from the total premium
contributions) is calculated for a specific financial year.
● The accounting of such activity should also account for unpaid claims, unearned premiums, etc.
to reflect the actual financial position of the takaful fund.

Rights of Policyholders to Surplus

● The policyholders or takaful participants have the right to the surplus, which is a product of their
contributions to the fund (see Box 8.2 which quotes from AAOIFI’s standard on the Sharī‘ah
ruling on surplus). This is to be clearly stipulated in the takaful policy.
● The shareholders (usually) are not entitled to the takaful surplus but will be reimbursed from
the profit realized from the investment activities of the takaful undertaking.

Allocating the Insurance Surplus

Listed below are a number of surplus allocation methods identified by AAOIFI:

○ allocation of surplus only among policyholders who have not made any claims during
the financial period
 ○ allocation of surplus to all policyholders, regardless of whether or not they have made
claims on the policy during the financial period
○ allocation of surplus among those who have not made any claims and among those who
have made claims of amounts less than their insurance contributions provided that the
latter category of policyholders should receive only the difference between their
insurance contributions and their claims during the financial period
○ allocation of surplus between policyholders and shareholders
○ allocation of surplus by using other methods

It should be noted that a takaful undertaking must agree on the distribution method in the
policy. AAOIFI cites that when the takaful policy or by-laws is silent on the specification of
allocation methods, the policy should always be designed so that all policyholders will benefit
equally from the surplus.

Covering the takaful deficit

● Takaful operators may provide a qard hasan (benevolent loan) to the takaful fund to undertake
the underwriting activities.
● Often times, retakaful companies come to the rescue of takaful undertakings by bailing out the
takaful fund.
● In most cases there are two main funds in the takaful undertaking (PRF and PIF); there are
different frameworks for covering a deficit in each instance.
● AAOIFI generally proposes a number of methods- (1) settling the deficit from the reserves of the
policyholders, (2) borrowing from the shareholders’ fund, (3) asking the policyholders to meet
the deficit pro rata, and (4) increasing future premium contributions, - for covering the takaful
deficit.

Deficits in Participants’ Risk Funds (PRF)

○ It is the takaful operator’s duty to rectify the deficiency and loss in the PRF.
○ Deficits may be rectified through qard hasan from the takaful operator, but in such
cases there must be a sound repayment mechanism that will not accept the PRF’s future
obligations.
○ In cases where the deficit is due to mismanagement or negligent behavior, it may be
rectified through the transfer of assets from the shareholders’ fund.

Deficits in Participants’ Investment Funds (PIF)

○ Any deficit recorded in the PIF is absorbed the capital providers (especially when takaful
undertaking is structured on a mudarabah model).
○ Loans cannot be used to guarantee a deficit because under Sharī‘ah, it is considered
impermissible for the entrepreneur (in this case, the takaful operator) to guarantee the
mudarabah capital.
○ Similarly to PTF funds, in cases where the deficit is due to mismanagement or negligent
behavior, it may be rectified through the transfer of assets from the shareholders’ fund.
D. Reinsurance and Retakaful?
Retakaful is the Islamic alternative to reinsurance (see Table 8.4 for an illustration of the differences
between the two according to Dr. Mohammed Ma’sum Billah).

● With regards to the conventional insurance industry, the risks underwritten by most insurance
companies are usually too great for them to continue with business so, reinsurance is a
mechanism to mitigate them by transferring the risks to a large insurer known as a reinsurer.
● The risk-averse method of retakaful is structured such that an agreed amount is paid
periodically from the operator’s takaful fund as premiums to the retakaful company; this way,
all the underwriting risks of the takaful operators are insured by the retakaful company (figure
8.7 illustrates the retakaful capital flow).
● The retakaful companies play a significant role when takaful operators record deficits or losses.
● The need for retakaful as the takaful industry developed was noted by the IFSB in its Guiding
Principles on Governance for Takaful Undertakings (an excerpt can be found in Box 8.3).
● A large initial capital is required for retakaful because of the large pool of risks involved in
reinsurance.

Table 8.4: Differences between Reinsurance and Retakaful

Differences Retakaful Reinsurance

1. Riba and gharar A retakaful operation does The conventional reinsurance
not earn commission as a operation is subject to riba
profit or interest, because and gharar, which are not in
this commission is subject to line with Sharī‘ah principles,
riba and dilutes the purpose e.g. the reinsurance
of setting up a takaful commission that the direct
operation. The retakaful insurance company earns,
operation is dependent on from the reinsurance treaty.
actual expenses spent by Because this commission
the takaful operator in the is framed in such a way, it
process of retakaful. renders the commission
ribawi and implies gharar to a
high degree.

2. Principle of insurable interest According to Islamic law Insurable interest is vested

insurable interest refers to in the reinsured party. The
holding a specific financial fact that the reinsured
interest in the subject matter party has issued a policy
of the insurance as a cardinal and assumed liability for
principle of the legality of its original insured party is
the retakaful contract. The assumed to give it insurable
reinsured party does not interest sufficient to enable
get an insurable interest or it to reinsure. The point is
 to reinsure the property of that although the reinsured
the original insured party party (direct insurance
without permission from company) has no actual
the policyholder. However, legal interest in the property,
because the retakaful the subject matter of the
operation is based on original insurance policy, it
mudarabah, it is vested with has assumed responsibility
a right to reinsure on the for it, and has therefore put
insurer because permission itself in a position, recognized
from the policyholder is by law, in which it would be
automatically inherent in the prejudiced by its loss.
contract of mudarabah.

● Since many retakaful companies are not large enough to attain an ‘A’ rating (which is typically
required for reinsurance purposes), takaful operators often opt for reinsurance policies of
conventional reinsurance companies; of course, with the permission of Sharī‘ah scholars.
● However, scholars unanimously agree that preference must be given to a retakaful company
where one is available.
● Retakaful operators must carry out their operations in accordance with the compliant structures
and models of the takaful operators.
● It is important to note that some conventional reinsurance companies have established takaful
pools, arms, or divisions based on the active demand for capacity from the takaful industry.

Box 4.3: IFSB-8 on Retakaful

As part of their risk management, takaful undertakings may subscribe to a retakaful scheme that suits
the needs and requirements for primary takaful undertakings to protect against unforeseen or
extraordinary losses. Retakaful can spread liability for specific risks, share liability when losses
overwhelm the primary takaful undertakings’ resources, and help them spread the risk inherent in
some segments of takaful business. Takaful operators should ensure that any retakaful arrangement
duly serves the purpose of the takaful undertakings and holds the interests of takaful participants
foremost. The pricing and protection o ered by the retakaful operator should be consistently reviewed
from time to time to ensure that it is commensurate with the needs and requirements of the takaful
undertakings. As far as possible, takaful operators should strive to use retakaful operators, rather than
conventional reinsurers, in support of a fully Sharī‘ah- compliant financial system for takaful
undertakings.

Islamic Finance in Practice: Swiss Re Retakaful

Some conventional reinsurance companies have established takaful divisions, such as Swiss Re in
Malaysia. The reinsurance company opened a dedicated retakaful branch in 2009. This branch came
into being as a result of increased demand for retakaful from the growing number of takaful
companies. Swiss Re introduced the wakalah-waqf model, which was developed to embed certain
sustainable elements of waqf into the model, beginning with the initial set up of a waqf fund realized
 through an initial donation by the retakaful operator. This model, which is endorsed by AAOIFI, has
since been adopted in South-East Asia, the Middle East and South Africa.

In Table 8.5 you can find a list of the most popular retakaful companies.

Key Terms and Concepts

aqilah (p. 298) surplus (p. 303)
contribution (p. 295) tabarru’ (p. 293)
hybrid takaful model (p. 305) takaful (p. 293)
mudarabah model of takaful (p. 302) takaful operator (p. 302)
mutual indemnification (p. 307) takaful policy (p. 315)
operator or wakil (p. 295) takaful ta’awuni (p. 294)
participants (p. 302) underwriting policies (p. 296)
participants’ investment fund (PIF) (p. 302) wakalah model of takaful (p. 303)
participants’ risk fund (PRF) (p. 302) waqf-wakalah-mudarabah model (p. 308)
qard hasan (p. 316)

Summary

1 Takaful is the Islamic alternative to conventional insurance. The underlying concepts of takaful
include ta’awwun (collaboration), tabarru’ (donations), and cooperative risk- sharing, which are
based on acceptable Sharī‘ah models.

2 The innovative Sharī‘ah-approved models and structures for takaful undertakings include the
mudarabah model, wakalah model, the hybrid model which brings together the first two
models, and the waqf-wakalah-mudarabah model. The models contain standard formulas for
the management of participants’ investment funds and the participants’ risk funds.

3 The available products in the takaful industry have been generally classified into two main
products—general takaful and family takaful. These are Sharī‘ah-compliant alternatives to
general insurance and life insurance, respectively. A general takaful contract provides short-
term takaful cover where assets and other proprietary belongings of participants are protected
from foreseeable material loss or any form of damage. Family takaful is a long-term policy
where people come together to mutually indemnify one another against any disaster that may
befall any of them, such as sudden death or permanent disability.

4 The process of determining and allocating any surplus or deficit as proposed by AAOIFI and the
different guidelines issued by the regulatory bodies in some Muslim countries emphasizes the
rights of the policyholders to the surplus. However, there is a current move to propose a
framework that would allow the shareholders of the takaful company to be entitled to a share
from any surplus.
 5 The relevance of reinsurance and retakaful to the modern takaful business is beyond doubt.
Although some scholars allow takaful operators to patronize conventional reinsurance
companies on the basis of necessity, preference is given to retakaful companies. However, there
is a need for retakaful companies to expand their capital base to be able to give insurance cover
to larger undertakings.

Practice Questions

1. What are the underlying concepts of takaful in Islam?

The three main concepts of Takaful in Islam are cooperative risk-sharing, clear financial segregation, and
Sharī‘ah-compliance in underwriting policies and investment strategies. In takaful, though policyholders
pay some sort of premium, they are considered as donations to the common cause to assist those
members who suffer any loss. This type of (1) cooperative risk-sharing aims to facilitate social
responsibility, solidarity, and the innate need to care for others. Under this cooperative arrangement,
riba and gharar elements are eliminated.

Fundamentally, Islamic insurance companies are not considered as insurers, but rather as operators
(wakils) in charge of managing the insurance portfolio and investing the insurance contributions (on
behalf of the participants). This concept is known as (2) clear financial segregation.

(3) Sharī‘ah-compliant policies and strategies are also an important concept within the takaful process.
These policies are used to determine the extent of risk-taking of insurance operators against the
payment of certain premiums are known as underwriting policies. Both the process and the end
products of the underwriting and investment mechanisms of takaful companies must be Sharī‘ah-
compliant; such compliance is determined by takaful companies’ Sharī‘ah governance system.

2. Differentiate between takaful and conventional insurance, with special reference to their main
features.

Please see Table 8.1, which lists the specific Differences between takaful and conventional insurance.

3. What are the differences between the mudarabah and wakalah models of takaful?

The mudarabah model of takaful is based on the Islamic finance product known as mudarabah (trust
financing), and is commonly used in trust financing. In this model, the takaful operator is the
entrepreneur (mudarib) appointed by the participants, who act as the financiers, investors, or fund
contributors (rabb al-mal). The funds contributed by the participants into the common pool of funds,
which is used for underwriting purposes, is known as the participants’ risk fund (PRF). The fund used for
investment activities on the other hand, is known as the participants’ investment fund (PIF).
When the PIF is invested in Sharī‘ah-compliant business, the profit is shared between the takaful
operator and the participants based on a pre-agreed ratio. The takaful operator is remunerated from
the underwriting surplus as agreed upon by the parties in the underlying takaful contract.

The wakalah model, the most widely used takaful model, is based on the Islamic finance product known
as wakalah (agency). This model is based on the contract of agency between the takaful participants
and the takaful operator, where the former are the real owners of the fund while the latter acts as an
agent. The takaful operator merely acts as an agent in the management and administration of the fund
(owned by the participants) for a contractual fee clearly specified and agreed upon by the parties. The
takaful operator in this model, unlike in the mudarabah model, merely acts as an agent and does not
share in the profits of the fund’s investment activities. Any surplus realized from the investment of the
participants’ funds will only go to the participants.

4. What do you understand as a hybrid model of takaful? Illustrate your answer with a suitable
example.

The wakalah model is employed for the underwriting while the mudarabah model is used for the
investment activities. Essentially the hybrid model is exactly as the term implies, a hybrid. Like in the
wakalah model, the takaful operator is entitled to an agency fee or a mutually predetermined
commission in their role as a wakil; however, additionally, they are entitled to a share in the profits
realized for managing the investment activities of the fund in their role as an entrepreneur. Many
scholars believe this model is the most suitable and mutually beneficial model for all the parties
concerned.

There is also another kind of hybrid model called the waqf-wakalah-mudarabah model. In this model,
the takaful companies’ shareholders make donations to a common pool of funds (which are invested in
Sharī‘ah compliant business activities) that has been established as a waqf, or charitable endowment.

5. Explain four main takaful models adopted in many countries around the world and describe the
parties to the takaful contract.

The four models are the mudarabah model, the wakalah model, the hybrid wakalah-mudarabah model,
and the hybrid waqf-wakalah-mudarabah model.

The (1) mudarabah model of takaful is based on the Islamic finance product known as mudarabah. In
this model, the takaful operator is the entrepreneur (mudarib) appointed by the participants, who act as
the financiers, investors, or fund contributors (rabb al-mal). The funds are contributed by the
participants into the common pool of funds, which are used for underwriting purposes, are known as
the participants’ risk fund (PRF). The fund used for investment activities on the other hand, is known as
the participants’ investment fund (PIF). These funds are both jointly owned by the participants. When
the PIF is invested in Sharī‘ah-compliant business, the profit is shared between the takaful operator
(considered to be the business partner of the participants) and the participants based on a pre-agreed
ratio.

The (2) wakalah model is based on the contract of agency between the takaful participants and the
takaful operator, where the former are the real owners of the fund while the latter acts as an agent.
The takaful operator merely acts as an agent in the management and administration of the fund (owned
by the participants) for a contractual fee clearly specified and agreed upon by the parties. It is important
to note that any surplus realized from the investment of the participants’ funds will only go to the
participants.

In the hybrid (3) wakalah-mudarabah model, the wakalah model is employed for the underwriting while
the mudarabah model is used for the investment activities. The takaful operator is, similar to the
operators role in the wakalah model, entitled to an agency fee or a mutually predetermined commission
in their role as a wakil or agent who manages the takaful funds. They are also entitled to a share in the
profits realized for managing the investment activities of the fund in their role as an entrepreneur.

Introduced by renowned Pakistani Sharī‘ah scholar Muhammad Taqi Usmani, the (4) waqf-wakalah-
mudarabah model, is a hybrid of the wakalah and waqf (charitable endowment) models with an
additional mudarabah element (see Figure 8.6). Under this model, which has been adopted by takaful
companies in South Africa and some other countries, the takaful companies’ shareholders make
donations to a common pool of funds (which are invested in Sharī‘ah compliant business activities) that
has been established as a waqf. The returns (not the principal, which is used for the continued
maintenance of the waqf fund) from the investments plus any contributory funds (tabarru’) in the
Participants’ Special Account (PSA) are used for the benefit of the participants.

6. What is the difference between family takaful and general takaful? Give relevant examples to
support your answer.

A general takaful contract provides short-term, but renewable takaful cover where the assets and other
proprietary belongings of participants are protected from foreseeable material loss or any form of
damage. The takaful participants pay certain specified contributions while the takaful operator
undertakes to manage the risk through the administration of the underwriting activities. A general
takaful fund is established (from the participants’ contributions) and used for Sharī‘ah-compliant
investments. The profits of such investments are returned to the fund for the purpose of
indemnification. General takaful is divided into two categories: motor and non-motor takaful. Specific
examples of claims covered by general takaful are, among many others, motor employer liability,
burglary, machinery breakdown, and medical.
Family takaful is essentially the Sharī‘ah alternative to life insurance. This type of policy, unlike general
takaful policies, is usually offered as a long-term policy cover that may span between 10 and 30 years.

7. How will you determine and allocate surplus in a takaful undertaking where surpluses have been
recorded at the end of the financial year?

I would remunerate from the underwriting surplus, both the takaful operator and the participants (as
agreed upon by the parties in the underlying takaful contract). Besides keeping the takaful company
competitive with conventional insurance firms in terms of profitability, incentivizes the agents to
perform better and encourages positive competition. The term “positive competition,” can be used
because if the takaful policy is designed in accordance with the Sharī‘ah, business practices carried out
by the agents to increase the surplus, will in most cases have to do with greater efficiency, better
investment decisions, etc., not deviation from the foundation of takaful.

8. What is the AAOIFI position on the allocation of surplus in takaful undertakings?

According to AAOIFI, “insurance or underwriting surplus is the excess of the total premium contributions
paid by policyholders during the financial period over the total indemnities paid in respect of claims
incurred during the period, net of reinsurance and after deducting expenses and changes in technical
provisions.”

9. What is the significance of retakaful in takaful undertakings?

Retakaful is the Islamic alternative to the conventional practice of reinsurance. Retakaful is a risk-averse
method through which Islamic insurance companies mitigate risks. Typically, an agreed amount is paid
periodically from the operator’s takaful fund as premiums to the retakaful company; this way, all the
underwriting risks of the takaful operators are insured by the retakaful company. Essentially, retakaful
companies come to the rescue of takaful undertakings by bailing out the takaful fund.

10. What makes retakaful distinctive when compared to the conventional reinsurance model?

Within the takaful framework, members contribute their financial resources to a common pool based
on the principles of ta’awun (mutual assistance) and tabarru’ (donation). Unlike in conventional
insurance, regardless of which takaful model being discussed, takaful claims are not reimbursed by
funds originating from the insurance company, but rather from a pool of funds created by the
individuals participating in the takaful arrangement. This arrangement encompasses mutuality and
shares the risk/loss/success among the insured. This model is completely different, both from a
theoretical and practical standpoint, from the conventional framework, particularly, as mentioned
above, which is fundamentally a buyer-seller arrangement, not a participatory vehicle like takaful.

Activities
1. Prepare a simple sketch of the mudarabah model adopted by most of the takaful operators in your
country.

Depending on where students are located, their sketches will be different. However, all of them should be
designed similarly to Figure 8.3, “An Example of the Mudarabah Model of Takaful,” which traces the flow
of the takaful money and the various types of funds and individuals involved in the mudarabah.

2. Find three newspaper cuttings on the recent development or expansion of takaful products in any
country.

Students should bring the cuttings that they find to class, where they will share their findings with other
classmates.

3. Prepare a brief profile of five major takaful operators in your country.

Similar to question 1, depending on where students are located, their answers will be different. However,
for their profile, for each description of the five takaful operators, they should identify the type of
contracts used, the investment strategy of the operator, the operator’s responsibilities within the takaful
arrangement, and the means through which the operator reinsures the takaful participants.

Margin Challenges

1. Can you establish any relationship between the development of the Islamic financial industry and
the emergence of the takaful component of the industry?

The idea of mutual assistance and cooperation is one of the most significant elements of Islamic
financial contracts. The practice of takaful, which is an alternative to conventional insurance based on
the principles of risk-sharing, was actually common among the early Arabs. The ancient Arab traders had
a common practice of insurance protection that was upheld and preserved by the Prophet based on
Islamic ideals. The concept of shared responsibility (aqilah) between the Muslims of Mecca and Medina
during the incident of the Prophet’s migration is a classical precedent of takaful. Since the emergence of
modern takaful products during the 1970s, the industry has witnessed tremendous growth. Some
multinational insurance companies have even opened takaful subsidiaries, which have enhanced growth
in the industry by an estimated 10-20 percent a year and could lead to a global takaful premium of
about US$25 billion in 2015. As we move forward, takaful products, especially commercial takaful
structures, will continue to remain an invaluable way for Islamic financial institutions and banks to
mitigate risk.

2. Why do you think the hybrid model of takaful is better than the single model?

Under the hybrid model of takaful, the wakalah model is employed for the underwriting while the
mudarabah model is used for the investment activities. Within the hybrid structure, the takaful operator
is entitled to an agency fee or a mutually predetermined commission in their role as a wakil or agent
who manages the takaful funds. Additionally, they are entitled to a share in the profits realized for
managing the investment activities of the fund in their role as an entrepreneur (mudarib). This dual role
has helped the hybrid model gain popularity and is the reason why many scholars have judged it to be
the most suitable and mutually beneficial model for all the parties concerned. The mutually beneficial
elements of this model make it better than the single model for several reasons; most notably, the fact
that the takaful operator’s sources of income are greater in this model, being the agency fee, incentive
fee, and the profit share from the investment of the funds (without sacrificing the coverage provided to
the takaful pool’s participants).

3. Name three examples of general takaful aside from the examples given in this chapter.

General takaful may also be called composite takaful because it, like general conventional liability
coverage, embraces a wide range of products. Students can essentially answer this question correctly
using just about any three examples (except specific items that would only be covered under coverage
enhancement policies- one example would be the loss of expensive jewelry).

4. What is the difference between takaful and retakaful?

Retakaful is the Sharī‘ah compliant alternative to the concept of reinsurance in the conventional
framework. Within the conventional framework, collective risk management is important in the
industry. In order to achieve this, insurance operators collectively share the risks they have undertaken
to underwrite. Larger insurance companies play this significant role as they underwrite the risks of
smaller insurance companies. Reinsurance is a mechanism to mitigate them by transferring the risks to a
large insurer known as a reinsurer, which accepts some of the smaller insurance companies’ risks.
Retakaful is structured so that takaful operators are participants in a takaful undertaking with a large
takaful company, which shares and does not accept the risks of the smaller insurance companies. An
agreed amount is paid periodically from the operator’s takaful fund as premiums to the retakaful
company. This way, all the underwriting risks of the takaful operators are insured by the retakaful
company. Essentially, retakaful is a takaful undertaking for takaful operators. The retakaful companies
play an important role when takaful operators record deficits or losses. The takaful operator, through
the takaful fund, underwrites the risks of the policyholders; the retakaful company underwrites the risks
of the takaful operator.