Takaful Insurance and Conventional Insurance: A Comparative Analysis - Case Study Example

Takaful Insurance and conventional Insurance: A Comparative Analysis Name Institution Course Date Takaful Insurance and conventional Insurance: A Comparative Analysis Introduction Insurance is a very important financial tool in all advanced economies. Insurance is particularly important as it provides people with a means to transfer the risk of uncertainty to the insurer with the insured paying an agreed premium to the insurer. In an insurance agreement, an insured undertakes to provide the insured financial compensation in the event that the specified loss occurs during the insurance period (Hussain & Pasha, 2014). Accordingly, insurance provides the society with an effective way of transferring the burden of uncertainty that they face in life for the certainty of premium. Since the premium if specific, the insured is certain that he/she will not pay more in a certain year. Although insurance is an important financial tool for cushioning against uncertainty, quite a large number of people opt to live without any form of insurance cover be it life assurance or property insurance. However, for activities such as driving a vehicle, it is compulsory for a person to have an insurance cover (Bekkin, 2007). Although the industry players understand how insurance works, the situation is different outside the industry, where the majority do not even know how insurance works and this contributes to the low insurance uptake by a significantly large number of people. Nonetheless, takaful being a new insurance concept is less well understood. Takaful is not well understood because of the complexity of how it operates, the arcane terminologies used and the tight rules governing the insurance business (Khan, 2011). The aim of this paper is to explain the differences between takaful and conventional insurance companies in terms of principle, terminologies, mechanisms and financial statements. Takaful Operational Model Takaful has become a common insurance practice in Islamic nations across the globe. However, considering the globalization of world economies, takaful is also increasingly finding its way into the non-Islamic states because of the growing population of Muslim communities as is the case in the United States. However, takaful is still less well understood in the Western world because it operates quite differently from the conventional insurance. Takaful operates on three models, which are key distinguishing practices from those of the conventional insurance and include mudharbah, wakalah, and WakalahWaqf models. According to the Mudharbah model, all the policyholders undertake to share all the losses and profits resulting from the undertaking (Hussain & Pasha, 2014). This implies that the operator does not pay any commission but only waits to get the share of the salary which is paid out of the share of the profits that the insurance company has made. How the profits are to be shared between the insurance company and the insured firms is predetermined in the insurance agreement, and this ratio of sharing profits must be approved by the Shariah Committee board. In most cases, the total expenses incurred under Takaful contracts are charged to shareholders. WakalahWaqf model is a fund that is created as a separate legal entity from the participants' contributions. The money deposited to WakalahWaqf is described as ‘tabarru' donation (Wahab et al., 2007). This fund is used to cushion the participants against specific losses that might arise under the terms and conditions of the WakalahWaqf. Wakalah Model holds that the excess policyholder's funds and the management expenses or fee is given to the policyholders. Here, the participants are expected to pay a fee from contributions to Wakalah. Conventional Insurance In conventional insurance, the main objective is to minimize risk exposure. Here a large amount of money is pooled from many policyholders that are then reinvested into instruments bearing risks. In the event that the policyholders incur specific losses insured against, the insurance company compensates for the loss suffered. However, conventional insurance is prohibited in Islam because it contains elements that are considered exploitative in Islam, such as Riba, Gharar and Maisir (Bekkin, 2007). In Islam, Riba means interest or increased principle amount that is supposed to be paid after a certain period. Maisir means gambling or speculation and describes a situation where the insured is expected to pay a premium for the insurance policy taken in expectation compensation in the event that a loss is suffered. In the event that the loss insured against fails to occur, the insured loss all the amount that he/she had paid as premium. On the other hand, in the event that the loss insured against occurs, the insurance company incurs a larger loss than the one collected from the insured while the insured gains by the same amount of loss suffered by the insurance company (Bekkin, 2007). Quran prohibits such kinds of gambling transactions, meaning that conventional insurance cannot be practiced in Islam. Gharar, on the other hand, means the uncertainty resulting from deception or lack of clear terms and conditions, which the Quran has prohibited. Differences between Takaful and Conventional Insurance The first major difference between the two is seen in the sense that takaful involves joint guarantee otherwise called Taawun, while conventional insurance is based on compensation for the loss suffered by the insured. Takaful's operations are based on the principle of Taiwan, which basically implies mutual help or cooperation. In this regard, the insurance under Takaful is conducted on the principle of brotherhood and trusteeship and solidarity. Conventional insurance, on the other, hand is based on material gains. Taawun, as earlier stated implies that the participants in the insurance contract comes together and agree to assist and guarantee each other by bringing together their contributions for purposes of cooperation (Wahab et al., 2007). In other words, in takaful insurance, the risk is transfer involves search party protecting each other from their risk exposure. Here, the aim of insurance is to bring about fairness and equity to all the parties involved. The objective of the parties taking an insurance cover in takaful insurance is to assist the policyholders during difficult times (Khan, 2011). The profits generated from the insurance contract are not the main goal as is the case in conventional insurance, though the profits generated is shared as predetermined. Takaful insurance also differs from conventional insurance in the sense that takaful operates on the mechanism of social solidarity or shared responsibility while conventional insurance operates on the principle of protecting the policyholders from uncertain risk. Takaful insurance is based on the principle of cooperation, social solidarity and joint indemnification of losses that the members taking the insurance might suffer (Bekkin, 2007). Here, the members come together and agree among themselves to jointly share responsibility for the losses that any of the members might suffer. To achieve this, the members contribute money collectively for use to cushion each other against any damages or losses that any of the members might suffer. On the other hand, conventional insurance involves indemnification of the insured or the policyholder by the insurance company in the event of loss insured against. The compensation under the conventional insurance is made in accordance with the policy terms and conditions (Wahab et al., 2007). Hussain and Pasha (2014) noted that takaful has developed as an innovation in the insurance industry, but also as a religious consideration. Takaful ensures that there is solidarity in case of any strategy in human life. In this respect, it seeks to ensure that no human suffering is caused. The Islamic model is based on the principle of cooperation and solidarity. On the other hand, conventional insurance has no religious attachments or boundaries. In conventional insurance, the main objective is to protect the policyholders from suffering losses in the event of damages or loss (Khan, 2011). The difference between Takaful and conventional insurance also manifests with regards to how risk is distributed. In takaful, there is no exchange of risk by way of contribution of payments to the operator. This implies that, in takaful insurance, the operator is not selling anything (Khan, 2011). At the same time, the participant is not involved in purchasing any risk coverage. Instead, the operator is only acting as the manager of funds on behalf of the participants (Bekkin, 2007). Therefore, there is no risk being undertaken by the operator. The distribution of risk only occurs among the participants that have mutually agreed to jointly assume the risk. By contrast, in conventional insurance, a contract is between two parties in which one of the parties, the insurance operator, agrees to indemnify the other party, the insured in the event of damage or loss suffered from the insured paying a premium during the insurance period (Khan, 2011). Takaful and conventional insurance also differ with regards to the investment of funds. Under conventional insurance, the there is no rule or boundary as to the type of assets that the insurance company can invest (Khan, 2011). This implies that conventional insurance companies can invest their money in any type of business, including alcohol, pork or gambling businesses. On the other hand, takaful insurance has a strict rule with regards to the investment of funds as Shariah prohibits investment in businesses such as gambling, alcohol or pork as they are considered haram (Wahab et al., 2007). Because of this, takaful invest their funds in interest-free ventures and follows the concept of Halal-o-Haram. Additionally, the difference between Takaful and conventional insurances manifest in terms of the nature of the contract. According to Hussain and Pasha (2014), Takaful insurance firms are riskier than conventional insurance companies in the sense that, whereas conventional insurance companies are free to invest in fixed income securities in their balance sheet that helps minimize their risk exposure, takaful insurance firms are prohibited under Shariah law from investing in interest securities. As such, they cannot invest in fixed income securities that generate income. Looking at the American multinational conventional insurance company AIG, which has operations in the United Arab Emirates, it can be seen from its balance sheet for the period ended 31 December 2015 that the company invested in fixed income securities 338,354 million and the same applies to 2014, when its investment in fixed income securities was $355,766 million (U.S. Security and Exchange Commission, 2016). On the other hand, a look at Abu Dhabi National Takaful Co PSC 2013 and 2014 annual reports indicates that the company did not invest in such fixed income securities as AIG because takaful companies are not allowed under Shariah law to invest in such securities (Abu Dhabi National Takaful Co PSC, 2015). Besides, conventional insurance contracts operate on the interest exchange principle. The relationship in conventional insurance is designed such that the insured or the policyholder pays a fixed sum of money in the form of premium to the insurance company that in return provides insurance coverage against losses that might occur to the insured risk (Khan, 2011). Contrastingly, under the Islamic Shariah law, an insurance business does not take the form of buying and selling contractual form. In takaful contract, all the policyholders in the contract have the right to know how the money they have committed in the insurance agreement is being spent and how the surrender value is computed (Wahab et al., 2007). Additionally, the policyholders in takaful insurance contracts must also be sure that the monies being paid out in claim settlements and the returns generated from the insurance business are acquired lawfully. For instance, the policyholders must be certain that the funds do not originate from investments, such as stock of companies that deals with non-halal products (Hussain & Pasha, 2014). On the other hand, conventional insurance does not give the policyholders any right to know about the sources of funds. The nature of the contract between the two also differs with regards to the conditions attached when it comes to termination of insurance contracts. In takaful insurance, when the policyholder decides to terminate the insurance contract even in a manner that is not provided for in the contract, all the premium that the policyholder has paid is refunded plus any surrender value less administrative fees (Wahab et al., 2007). By contrast, in conventional insurance, whenever the insured decides to terminate the policy, he/she immediately forfeits the premiums paid. In other words, the insurance company will not refund the premium to the insured. Lastly, takaful and conventional insurance differs with regards to how profit is distributed. Under takaful insurance contract, the policyholder has the right to be told how the profits generated from different investments that are undertaken are shared among the participants. Contrastingly, in conventional insurance, there is no rule for distribution of profits as it is the management's responsibility to determine how profits are distributed (Hussain & Pasha, 2014). Conclusion Takaful is an Islamic equivalent of insurance. Takaful have grown significantly in the recent past both as a result of innovation and as religious influence. However, as demonstrated in the paper, takaful differs from conventional insurance in many ways, which include the fact that takaful involves mutual agreements between parties to help each other in the event of loss with no premium paid apart from individual contributions while conventional insurance involves one part undertaking to indemnify the other in the event of damage or loss against the insured property. Additionally, the two differs in terms of the nature of contract, investment, operations, terminologies and mechanism. References Abu Dhabi National Takaful Co PSC. (2015). Annual Report. Retrieved from http://quote.morningstar.com/stock-filing/Annual-Report/2014/12/31/t.aspx?t=XADS:TKFL&ft=&d=db0aa8c6d0bb220901d748830dfd9221 Bekkin, R. I. (2007). Islamic Insurance: National Features and Legal Regulation. Arab Law Quarterly 21, 109-134 Khan, L. A. (2011). How does takaful differ from insurance? The world takaful report. Retrieved from http://ara.assaif.org/Working-groups/Takaful Hussain, M. M., & Pasha, A. T. (2014). Conceptual and operational differences between general takaful and conventional insurance. Australian Journal of Business and Management Research, 1(8), 23-28. U.S. Security and Exchange Commission. (2016). American International Group, Inc. Form 10-K. Retrieved from http://www.aig.com/content/dam/aig/america-canada/us/documents/investor-relations/aig-december-31-2015-form.pdf Wahab, A.R.A, Lewis, M.K. and Hassan, M. K. (2007). Islamic takaful: Business models, Shariah concerns and proposed solutions. Thunderbird International Business Review 49(3), 371-396. Read More