Takaful Insurance: Bridging Tradition and Modernity in Insurance Practices

June 04, 2024

Estimated reading time: 7 minutes

In the ever-evolving landscape of global finance, Takaful emerges as a beacon of ethical and cooperative insurance, marrying traditional Islamic principles with contemporary financial needs. This form of mutual insurance not only adheres to Shariah laws but also addresses the ethical concerns of consumers seeking alternatives to conventional insurance methods.

Market Overview

The global takaful market size reached approximately USD 33.91 billion in 2023. The market is projected to grow at a CAGR of 13% between 2024 and 2032, reaching a value of around USD 102.02 billion by 20321.

With high market competition, takaful serves as a strong business proposition and is also gaining momentum among non-Muslim clients, witnessing a steadily increasing share. Actuarial societies like SOA and IFoA have a rich collection of published studies and research papers on takaful built over time as well.

Core Principles of Takaful

Derived from the Arabic verb "kafala," meaning to guarantee or to take care of, Takaful embodies the concept of shared risk, responsibility and mutual support. Unlike conventional insurance where risk is transferred from the insured to the insurer, Takaful operates on the premise of shared risk. Participants contribute to a common pool, which is used to indemnify members against loss or damage. The premium or contribution is seen as a form of donation or ‘tabarru’ where person can get protected if the covered misfortune befalls him/her, otherwise the contribution can still go towards supporting those upon whom the covered misfortune has befallen. This cooperative model aligns with the Islamic values of brotherhood, solidarity, and social welfare.

Unlike conventional commercial insurance designed to generate profits, takaful is conceived as a non-profit philosophy of mutual assistance. All contributions made by participants are pooled together with the intention of extending gratuitous financial aid to any member suffering a specified insured loss. Any surplus funds are wholly owned by the participants collectively rather than shareholders.

The following table, taken from SOA’s report ‘Takaful, an alternative approach to Insurance’, shows this takaful business model illustration to build a conceptual understanding of takaful business:

Ethical Investment Principles

Takaful products and operations adhere to the ethical investment principles laid out in Shariah law. This means avoiding any element of uncertainty (gharar), usury/interest (riba), or dealings (covering or investing) in prohibited activities like gambling, alcohol and pork. Takaful funds cannot be invested in interest-bearing accounts or businesses involved in non-permissible trades. Takaful also has to remain separate from conventional finance such as conventional insurance, conventional banking, conventional reinsurance and conventional investments.

Shariah Compliance and Supervision

To safeguard adherence to Islamic jurisprudence, takaful companies operate under the supervision of dedicated Sharia supervisory boards or advisors. These religious scholars scrutinize all contracts, investments, claims processes and business activities to ensure full compliance with the precepts of Sharia at all times.

Takaful Models

Takaful structures are meticulously designed to ensure compliance with Islamic jurisprudence. The two predominant models are Mudharabah (profit-sharing) and Wakalah (agency). Under Mudharabah, participants act as capital providers, while the Takaful operator serves as the entrepreneur. Profits generated from investments are shared between the participants and the operator based on a pre-agreed ratio. This arrangement not only provides coverage but also offers potential financial returns to participants. Under Wakalah, the Takaful operator acts as an agent for the participants, managing the fund for a fixed fee. The operator is responsible for underwriting, claims management, and investment of the pooled funds. Any surplus after claims and expenses can be distributed among participants or retained within the fund to enhance future stability.

Practically, the hybrid waqf-wakala is implemented so that there is both a top line incentive and bottom-line incentive for the wakeel or agent. Waqf refers to a charitable endowment or trust established under Islamic law, which is used as a part of the business model to create a pool of funds dedicated to providing financial protection to its members. Wakala fees is deduction from the contribution that goes towards paying of the agent’s expenses. Net of wakala contribution is put in policyholders’ fund to pay the claims incurred there. Mudarib share is also there which is a percentage of profits from investment that goes to the agent. There are two accounts so that the items under division can be seen clearly. Policyholders fund handle the claims for the pool and shareholders account takes in wakala fees as revenue to pay off its expenses such as commissions and management expenses. The surplus from the policyholder fund can be paid to the policyholders as they are the owners of that pool and the takaful insurer is just an agent organizing the people into that pool. Surplus can be withheld and built as reserve to serve as contingency for future adverse experiences too. In case of deficit in the policyholder account, the shareholder account has to cover this by providing an interest-free-loan which is called qard-e-hasan (literally translating to a beautiful loan). Then the policyholder has to first pay off this qard-e-hasan and only after it has paid this off can it pay the surplus to its policyholders. Thus, setting an optimum wakala fees becomes paramount. The wakala fee should not be that low that the insurer has to bear loss and is not able to cover its expenses but it also should not be that high that its deduction leads to successive deficits in policyholder account.

Technical Differences in Takaful

Our articles hardly touches the tip of the iceberg. There are many differences that requires unique attention when handling reserving, product development, pricing, investment and application of financial regulations like IFRS17 as well as national regulations. These would become too technical quickly but to give a glimpse into some of these points, following items are worth noting:

  1. Wakala fees is not seen as premium but as fees so should be recognized over time instead of over the policy contract duration under IFRS17.

  2. Risk adjustment should be calculated on policyholder part and not on shareholders’ fund.

  3. Health has experience refund for conventional insurance where some large groups, based on their high bargaining power, negotiate that some portion of unspent premium will be given back by the insurer to the client. This is not allowed under takaful because it doesn’t give unspent premium back to only those few clients with high bargaining power but to all customers under policyholders’ fund.

  4. Premium deficiency reserve (PDR) can be potentially lower under conventional insurance than takaful as about half of expense ratio is only taken to represent maintenance expense ratio for PDR assumption setting whereas contribution deficiency reserve (CDR) can be based on loss ratio net of wakala deduction which is higher than the maintenance expense.

  5. Simple changes in product features. For instance, health and life wellness might give cinema tickets if weekly targets are met but this feature is not allowed under takaful.

  6. Problems arise when seeking long term retakaful (alternate to conventional reinsurance) with deep capacity and long term sukuk (Islamic bonds) to invest in to match the long-term duration of their insurance liabilities.

Regarding surplus distribution, another point is that people can choose to take those amounts or pay them to their chosen charities. This gives the comfort that any unspent money is paid towards social impact causes and the larger the surplus, the more impact this feature can make.

The concept of a more ethical insurance is not just restricted to takaful but also to other forms of insurance such as mutual insurance which operates upon similar principles. With Insurtech looking to build more ethical business models, they have also adopted models similar to takaful. For instance, Lemonade acts like an agent who deducts their fees from premium (like wakala fee) to pay off its expenses and rest goes towards policyholders account to pay the claims; any surplus can be donated to chosen charity or taken back. Laka Insurtech has adopted another takaful model which is that premiums are not required upfront and claims in pool are calculated over end of term such as end of the month and then a specified portion of claim is billed to the policyholder to be paid as a result of their participation in that pool.

Alibaba2 has launched various innovative insurance products, such as Xianghubao, a mutual aid service available on the Alipay platform. This service is designed to provide mutual aid for medical expenses, particularly focusing on cancer care for elderly users. Unlike traditional insurance, Xianghubao operates on a mutual aid basis, where users share the costs of claims amongst themselves.

Challenges and Opportunities

Despite its numerous advantages, Takaful faces certain challenges that need addressing to unlock its full potential. These include regulatory inconsistencies across different jurisdictions, limited awareness among potential users, and the need for more skilled professionals in the Takaful sector. Takaful players are not that well established as insurers and don’t have as deep pockets so budgeting to match conventional insurance’s people, software, commission levels etc. becomes a challenge. Awareness of takaful is limited even in Muslim majority countries. In Muslim majority countries, there is lack of awareness for concept of insurance broadly and takaful can be skeptically seen as pulling one ear instead of the other due to lack of trust around insurance built due to aggressive sales tactics. In non-Muslim countries, the Arabic terminologies can be seen as being limited to Muslims, rather than seeing takaful broadly as part of ethical insurance. For example, Nigeria is a secular country and even though it has majority Muslim population, takaful terminologies cannot be used there and it has to be referred as ethical insurance so each country has its own dynamics too3.

The Future of Takaful

However, the future of Takaful looks promising. With the growing demand for ethical financial products and the increasing integration of Islamic finance into the global market, Takaful is poised for significant growth. Innovations in digital technology and regulatory harmonization are likely to enhance its accessibility and efficiency, making it an attractive proposition for a broader audience. This can lead to streamlining of operations at lower costs which is important specially in cost-sensitive but massively social impacting insurance like micro-insurance and index insurance.

Overall, Takaful stands as a testament to the harmonious fusion of ancient principles with modern financial needs. It offers a robust framework for risk management that is not only economically viable but also ethically enriching. As the world continues to seek more inclusive and responsible financial solutions, Takaful's unique model of mutual assistance and ethical investment is set to play a pivotal role in shaping the future of global finance.

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