Takaful Basics

Historical precedent for Takaful & Takaful in the world today

Various kinds of insurance schemes existed in the pre-Islamic period in the Arab world, many of which continued into the Islamic era. Under Umar ibn Al Khattab, the Khalifa Ar Rashideen, the government encouraged residents to perform Al Aqilah; the practice of sharing blood money liability among a specified group of people.

The system of Aqilah was further expanded in the second century of the Islamic era when Muslim Arabs began trading in India and Asia. Groups of traders would enter into a joint guarantee to help one another in times of disaster or misfortune. As time advanced, other insurance schemes were created until the 19th century, when a Hanafi jurist, Ibn Abidin (1784 - 1836), introduced the idea of insurance as a legal practice in Islamic jurisprudence.

‘Takaful’ stems from the Arabic verb ‘kafala’, which literally means ‘mutual guarantee’ or in a broader sense, a treaty guaranteeing members in a group against damage or loss suffered by any of them.

The first modern Takaful companies were established in 1979 in Sudan by Faisal Islamic Bank and subsequently other companies were set up in Bahrain and the UAE. In 1984, Malaysia passed the Takaful Act that served as a launchpad for takaful companies. To date, there are more than 300 takaful companies operating in various regions worldwide.

The “global takaful insurance market was valued at $24.85 billion in 2020, and is projected to reach $97.17 billion by 2030, growing at a CAGR of 14.6% from 2021 to 2030”. This growth has been driven by three main markets, Saudi Arabia, Malaysia and Iran and continues to be rooted in traditional financial infrastructure. Despite this large growth opportunity, there have been no notable takaful companies in the crypto and web3 world.

Fundamental principles of Takaful and Shariah compliance

Takaful is defined as “a scheme based on brotherhood, solidarity and mutual assistance which provides for mutual financial aid and assistance to the participants in case of need whereby the participants mutually agree to contribute for that purpose.”

In practice, a group of individuals pool funds together with the intention of providing financial assistance to one another as insurance against a defined risk. The intention, or niyah, is that of mutual aid and stems from the fact that the funds are contributed as donations, partial or full, for the specific purpose of insuring against risks. The funds are used to compensate the Takaful Operator (the company that manages the funds on behalf of the participants), to pay claims against adverse events, and invested for returns. In case there are funds remaining after these activities, they are redistributed back to the original contributors.

It is easiest to understand takaful in contrast to conventional insurance.

Takaful vs. Conventional Insurance

	Takaful	Conventional Insurance
Purpose/Intention	Mutual aid and risk sharing	Risk transfer
Operator/Company	The Takaful operator manages the funds on behalf of the participants as a group and is paid an operating fee and some incentive on investment returns (if any)	The relationship between the insurance company and policyholders is on a one-to-one basis. Policyholders are customers. Premiums are revenue for the company
Insurer v. Insured	The participants are both the insurer and the insured and bear the risk and reward from insurance activities	The insurance company is the insurer and bears all the risk and reward from insurance activities. The customer is the insured.
Payment of Contributions/Premium	Contributions are paid as partial or full donations	Premiums are paid as an expense and cost of purchasing an insurance policy
Ownership of Contributions/Premiums	Contributions are owned by the participants as a group	Premiums are owned by the insurance company
Use of Contributions/Premiums	Contributions are used to pay claims, direct expenses of the fund, takaful operator fees, and invested for returns	Premiums are revenue for the insurance company, they are used to pay claims, operating costs and invested for returns
Treasury Management	Invests in shariah compliant investment vehicles only	No restriction on types of investments
Underwriting Surplus/Loss	Belongs to the participants	Belongs to the insurance company
Investment Returns/Losses	Belongs to the participants	Belongs to the insurance company

Takaful in light of the Shariah

As we highlighted in the section on Islamic finance and insurance, there are 3 main principles that cause conventional insurance to fall outside of shariah boundaries. Let’s examine how Takaful resolves these issues.

1. Prohibition of Riba (Interest)

Takaful funds are invested in shariah-compliant investment portfolios that are free from riba. Moreover, because takaful contributions are intended as donations for a specific purpose, they are not loans with interest; while claim payments are usually larger than contributions, the excess amounts paid are considered donations from others in the community, and not interest on a loan.

2. Prohibition of Gharar (uncertainty)

Gharar is broadly defined as “uncertainty and risk-taking as well as excessive speculation, gambling and ignorance of the material aspects of contracts”. Gharar invalidates financial commutative (muawada) contracts, in other words, contracts that exist with a commercial purpose. Gharar does not invalidate gratuitous contracts based on donations (tabarru). If we take the example of a lottery, it is considered a commercial contract with excessive gharar and is therefore invalid and impermissible. A donation for a specific purpose (such as takaful contributions) is a gratuitous contract as there is no expectation of return as long as the specific purpose is fulfilled. Hence, gharar does not invalidate takaful contracts and they are permissible.

3. Prohibition of Maisir (gambling)

One of the criticisms by scholars against conventional insurance is that it contains an element of gambling (maisir). While there are differences of opinion in this matter, scholars are in agreement that takaful is free from maisir. As takaful is based on mutual aid and contributions are donated for the specific purpose of mutual aid, there is no possibility of loss and all participants’ interests are aligned.

The fundamental principles of Takaful are widely accepted by Islamic scholars worldwide, including The Islamic Fiqh Academy, the Higher Council of Saudi Ulemas, the Fiqh Council of the World Muslim League, and the First International Conference for the Islamic Economy. In practice, the operational models of various Takaful companies still require regular auditing to ensure compliance with shariah principles.