Introduction
Finance can be defined as a branch of economics that deals with resource allocation, resource management acquisition and worthy investment. Financial management, in this case, is the study and practice of making financial decisions. About 25% of the world’s population is Islam. This percentage is fairly distributed across the globe with the Middle East and Afghanistan, registering the highest populations.
This essay shades light on Islamic finance. The essay will strive to introduce, discuss, analyze and draw conclusions on Islamic Finance. Its main aim is to provide a clear understanding of the growth of Islamic finance by exploring its current and future advancements. The essay explains the characteristics of Islamic economies, highlights and explains the fundamental differences between Islamic economies and other economies. The essay also describes how Islamic finance will enhance and maintain economic justice within the Muslim community and other religious outfits. The essay will conclusively define the role of Islamic finance in the Islam context.
It has been said that a pre-Islamic practice of Aqilah, blood money, is the basis of the distribution of loss instead of transfer of loss in modern Takaful practice. Can you explain how Aqilah is linked to modern Takaful?
Aqilah is considered as a form of blood wit. It implies that when one’s kinsman is killed, his tribe can be brought camels as a settlement of the blood wit. Aqilah is a group of people who have to pay blood in compliance with the Sharia law. Aqilah has its origin in an ancient Arab tradition which had the belief that when a member of their unit suffered harm of loss of life or property, it was the duty of the unit or the perpetrator to cover such loss through repayment.
Islam is bound by the same principle of Aqilah and diet, which imply social responsibility and blood money, respectively. This age old practice of compensation is considered the foundation for Takaful insurance system, which was defined along the line of Islamic beliefs and guided by the rules and the regulations of Islam or rather Sharia law. Takaful has the responsibility of encouraging people to take care of the needy while ensuring the financial stability of their kin and to further ensure that there are responsibility and bonding together in the society (Eek 1).
What are the key differences between Takaful and conventional insurance? List and discuss three of these differences
Takaful is the Islamic version of conventional insurance. Takaful is founded on the concept of mutual solidarity; its undertaking comprises of two main tier-structures that is: a hybrid of a mutual as well as a commercial form.
This form of structure presents a lot of challenges regarding supervisory and regulatory issues. Islam has no problem against any form of insurance, but it has some reservations regarding the practices of conventional insurance; this was evidenced by the fact that the principle of mitigation of risks was first applied in Islam insurance and it has now been adopted by the conventional insurance. The Islamic form of insurance or Takaful discourages the levying of interest and gambling. The main areas of divergence between the Islamic form of insurance and conventional insurance are:
Riba or Usury
This implies the earning of interest; Takaful system of insurance prohibits interest while conventional insurance permits it. In Islamic financing, levying of interest is forbidden in accordance with the Quran.
Uncertainty or Gharar
Gharar involves all activities which are executed basing on probability. Islamic financing does not encourage contracts based on ‘guesses’ or rather probabilities. Gharar is therefore forbidden by the Takaful system of insurance but rather forms the foundational basis for conventional insurance.
Gambling or Maisir
This is prohibited by Islam; hence by the Takaful, the conventional system of insurance permits gambling.
The differences between Takaful system of insurance and conventional insurance are evident in the following aspects:
Contract
According to Takaful, contract combines Tabarru, which is a donation and the agency. The contract also includes a profit-sharing contract between the individual insured and the pool of the insured as represented in the Takaful. On conventional insurance, a contract is a policy document that governs the terms of insurance between the insured or the policyholder and the insurance company. The operator can also provide the interest-free loan in the event of deficiency so as to cover it.
Responsibility of policyholders
With regards to the conventional insurance, the policyholder has the responsibility to pay premiums to the insurance provider or the company, but in the case of Takaful, participants only have the duty to contribute to the insurance scheme. In the situation of surplus, the participant benefits and in the event of a deficit, liability is transferred to the policyholder. Underwriting, in the case of Takaful, is managed by the operator under the Mudaraba contract.
Liability of the operator or the insurance company
In the conventional insurance system, the company is under liability to pay claims through underwriting fund and in some circumstances through the shareholder’s fund. On the Takaful system of insurance, the operator acts have an administrator of the scheme, and he pays the benefits through the underwriting fund (Islamic Financial Services Board 6).
Explain the family and general Takaful. List the different types of family and general Takaful products available in the market
A family Takaful plan is one of the savings and investment programs that have a fixed maturity period. In this plan, the participant enjoys investment profit while the plan also offers mutual financial assistance to its participants.
General Takaful, on the other hand, is a practice where the participant contributes large sums of money into a Takaful fund which can be in the form of Tabarru or participative contribution. In the case of general Takaful, the participant enters into a contract so as to mutually contribute towards the Takaful fund.
The family Takaful is a form of financial program that pools efforts in aiding the needy in the event of need or emergencies like death or mishap. While general Takaful is a contract based on the principle of joint guarantee, and it is on a short-term basis, in the event of a mishap, the owner of the property bears the loss. Contribution in general Takaful is in the form of donation and involves the sharing of profits. In the case of family Takaful, the participant decides on the amount of money he is willing to part based on his/her preferred mode of instalment, whether monthly or yearly.
The products that are available under family Takaful are investment-linked Takaful, child education Takaful, Medical and health Takaful, family Takaful mortgage plan and family Takaful. Consequently, the products that are available in the market relating to general Takaful are home Takaful, motor Takaful and personal accident Takaful.
Given the fact that uncertainty exists only as to how and when an individual will die; can you explain how Islamic law allows the operation of a family Takaful life insurance scheme?
In the case of Takaful life insurance scheme, the participant should nominate a person who, in the event of death or any eventuality, can execute over the benefits of the Takaful scheme. The benefits should be distributed according to the Islamic law of inheritance when the participant dies. The person nominated receives the benefits only as a trustee; in the case where the nominee is not a Muslim, he/she should be considered to be an automatic beneficiary.
Consequently, the participant can bestow the benefits to an individual as a donee, and in this case, the benefits from the scheme are given in advance as a gift in favour of the donee. In this circumstance, the donee becomes the outright beneficiary of the benefits. In the case of conventional life insurance, the beneficiaries are not subject to any claim unless in the circumstance where the participant commits suicide within two years into the contract (Ali 1).
Compare and contrast the three different models of managing Takaful plans: Wakalah, Mudharabah and the mixed Wakalah/Mudharabah model. Focus on the following points:
- Fees.
- Level of profitability of Takaful operator.
- Suitability for family or general Takaful.
- Surplus.
Takaful plan utilizes three different kinds of models: Wakalah model, Mudarabah model and a mixed model, also called Waqf, which combines the principles of both Wakalah and Mudarabah models.
Fees
In this case, the Takaful operator receives payments from the participants based on rules of equity partnership. The profits are shared equally among the parties as per the terms of the contract. In this case, the participants provide the capital while the operator is the entrepreneur. In the case of Wakalah, the shareholders are the ones who provide the capital which can be in the form of donations.
In this arrangement, they don’t receive any share from the income generated from the investment. It generates its income by charging a fee referred to as Wakalah fee. In Wakalah, the participant appoints an operator who will act as an agent at a fee which is referred to as a secured agent fee. It is the operator that fixes the fee which they deduct from partners contribution. This agency fee covers all areas of Takaful investments. In the case of Mudarabah, agency fees are not charged. The mixed model adopts both fee-based and profit-based principle (World Takaful Report 1).
Level of profitability of Takaful operator
Mudarabah model generates a lot of surplus and profit due to the fact that the contributions by the participants can be invested. This is unlike Wakalah, which does not generate a lot of income and only operates on a risk-sharing basis. The Takaful operator reaps a lot of profit in the Musharabah model when compared with other models.
Suitability for family or general Takaful
Mudarabah in the case of a family Takaful may not be appropriate. The funds from the general Takaful cannot be invested, and it is only the participants who can choose to invest their premiums in particular funds.
Surplus
In the case of Mudarabah, surpluses are obtained from the activities and the operations of the Takaful system. The surplus can only be shared after the Takaful operations have fulfilled the desires of the participants. Sharing of the surplus acts as an incentive to the participants and more so to the operator in order to execute the underwriting process in an effective manner and also to manage the claims properly.
There is no sharing of underwritings in the case Wakalah; there is the only negotiation of expenses by the operator on behalf of the participants (Financial Islam 1). In some circumstances, the parties share the surplus as an incentive fee for the operator where the operator gets upfront agency fees based on the underwriting surplus. In the mixed or the hybrid model, the surplus is shared based on the Mudarabah model, and at the same time, the operator receives secured income in the form of agency fees.
Briefly describe how an underwriting surplus is distributed under the AAOIFI standard
Distribution of surplus is considered to be a fundamental operation in Takaful business. It acts as an instrument of providing mutual guarantees at possible risks. There are three recognized ways of distributing surplus; these are the pro-rata model, selective mode and offsetting mode. The AAIOFI standard on Takaful operations indicates that the underwriting of surplus and its returns, less the expenses and the payment of claims are considered to be the property or the share of the policyholders or the participants, this is distributable surplus. This form of calculation is not applicable in the commercial insurance sector. Based on this assertion by the AAOIFI, the issue of claim over premium ownership is considered (Soualhi 3).
On the pro-rata, the underwriting surplus can be distributed based on the premiums paid by the participants without putting many efforts on the difference between the claimable and non-claimable assets accounts. Selective mode, on the other hand, only indemnifies non-claimable accounts. Off-setting mode offsets the underwriting out of the amount claimed, and it is only practical on those accounts with more claims than the underwriting surpluses.
Why might an insurance company need to get insurance from another insurance company?
The practise where insurance companies choose to be insured by another insurance company is referred to as reinsurance. This will permit the insurance companies to pass those risks that they may not wish to handle or absorb. Insurance companies choose to insure part or whole of their risks that they are exposed to with specialist reinsurers. In this arrangement, the insurer recovers part of the claims paid out from insurers.
This has the ability to reduce the risks of failure of the insurer in the event of calamities which produce a higher degree of claims. Companies dealing with reinsurance are very big, have access to massive funding and widespread operations. Their measures of risks, for example, risk margin, are always adjusted. Reinsurance arrangement is found in two forms: facultative and treaty reinsurance. In facultative reinsurance, each risk that the insurer underwrites is a product of separate arrangement. In the treaty, reinsurance is an arrangement for a block on insurer’s underwritten policies. A big portion of the insurers business is reinsured by the reinsurer (Money Terms 1).
Which of the following statements relating to Takaful are true, and which are false? Briefly explain your answer.
A Mudharaba contract is a contract of management between the Takaful participants and the Takaful operator
True: this statement is true in the sense that Mudharabah is one of the models of Takaful where the participant makes contribution to the operator. In this case the income from the investment is shared between the two parties based on the terms of the signed contract. The contract also entails how much should be contributed by the participant. The contract also entails the fact that the participant shall be entitled to the entire underwriting surplus and no deduction will be made
Tabarru3 is a donation contract given in favor of the Takaful operator
True: based on this principle of Takaful, the participant’s premium should be paid as a form of donation. This is aimed at eliminating the Gharar or uncertainty from the contract in order to make it conform to the principles of Islamic insurance system. During the donation contract, all participants requiring protection would be available so as to demonstrate their desire to donate to any other Takaful participant who may be faced with difficulties (Tlemsani 99).
The Takaful operator can manage the Takaful operations and investments on the basis of a Wakalah contract
True: in the case of Wakalah model of Takaful, the operator only acts as an agent of the participants and is only responsible for managing the Takaful fund. The contributions in Wakalah model are not motivated by the desire to make profit; it is only the pooling of risks. The operator only acts as a custodian of the fund. All surpluses belong to the contributor.
Actuarial principles help to decide the appropriate amount to be donated by the participant toward the Takaful fund
True: actuarial principles are applied in the calculation of the amount to be contributed by the participant to the Takaful scheme. This is evidenced by the fact that there is an actuary department in insurance companies that practice Islamic banking. The actuary has the duty to determine the amount to be contributed by the participant by analyzing mobility rates. It is the actuary who determines the Takaful plan, costing and the projector investment plan.
Donation or Tabarru3 is the basis for mutuality in Takaful
True: participants make their contributions to the Takaful fund in the form of donation. The participants are bound by a contract they sign as an agreement mutually assist each other in times of calamities; this calamities might arise in the form of death o physical injury or any misfortune that is covered by the terms of Takaful. Consequently, the premiums collected from the participants are treated as donations and are invested under the Takaful fund and it is regularly reimbursed (Islamic Law of Finance 1).
Modern Islamic insurance did not exist until 1980
False: Takaful is form of insurance company that is based on Islamic commercial law. Its development in the modern times was initiated in Sudan in 1979 and gained prominence after being practiced in Malaysia in 1984; this led to the declaration of the conventional insurance as illegal or for bidden or Haram in 1985.
Distribution of loss is similar to transfer of loss
False: the two terms are not similar. Islam does not allow the transfer of risks or loss to another party and instead advocates for the sharing of losses. It is only in conventional insurance where risks are transferred.
Can you think of an occasion where moral hazard could arise if the requirement of insurable interest did not exist?
Moral hazard implies that people will only take risks when they are provided with incentives. This might lead to the ignorance of the moral implications that might emanate from the risks. Moral hazard operates on the principle that once you are much insulated from risks, temptations emerge. Insurance interest is the restriction of valid insurance cover for those who demonstrate particular type of interest in property and the life that is to be insured. Insurance interest is only aimed at eliminating or preventing moral hazard.
Regarding to moral hazards, insurance cover is to be restricted so as to prevent it from becoming an incentive for unwanted behaviors like crime. This can happen for example in a scenario where a one individual can insure the life of a stranger and after sometime kills the stranger in order to obtain the payment (Law Commission and Scottish Law Commission 9).
Works Cited
Ali, Kazi. About Takaful (Islamic Insurance). Prime Islamic Finance, n.d. Web.
Ayub, Muhammad. An Introduction to Takaful – An Alternative to Insurance. Islamic World, 2003. Web.
Eek, Tee. Takaful for all. Takaful, n.d. Web.
Financial Islam. Takaful Business Models. Financial Islam, 2011. Web.
Islamic Financial Services Board. Issues in regulation and the supervision of Takaful (Islamic insurance). Insurance Financial Services Board, n.d. Web.
Islamic Law of Finance. SHARIAH ISSUES IN TAKAFUL. Islamic Law of Finance, 2010. Web.
Money Terms. Reinsurance. Money Matters, 2011. Web.
Soualhi, Asa. Shari’ah inspection in surplus distribution: Shari’ah views in current implementation. Scribd, 2008. Web.
Tlemsani, Issam. Islamic banking. Abu Dhabi, UAE: Higher colleges of technology, 2010. Print.
World Takaful Report. UAE Laws and Islamic Finance: Takaful Management Models. World Takaful Report, 2010. Web.