How does Takaful Life Insurance work?

Posted on: 6th September 2017 in Insurance

Takaful, Islamic life insurance, is available to non-Muslims (so that means us expats in the UAE) and can often offer better deals than conventional insurance – as well as more rigorous ethical values. But how does it work? Takaful has been winning over people internationally for taking a different approach to providing compensation in the face of unfortunate circumstances.

“No-fear Shari’ah”: Takaful life insurance in a nutshell

While ‘Ta’mein’ is the rough equivalent of ‘insurance’, ‘Takaful’ roughly means ‘solidarity’ – and this goes some way to conveying its underlying ethos. The earliest Middle Eastern insurance developed more than 800 years ago and was marine insurance, with traders forming what could be called a mutual society and a common pot from which members could be compensated in the case of calamity on the high seas. Communities also pooled their contributions to help members financially when they fall on hard times. This is where the ‘solidarity’ comes in: help thy neighbour, just as you’ll be helped. This semi-formal insurance arrangement still happens informally today, such as in Yemen. But insurance doesn’t just compensate for catastrophe – it mitigates risks. Today, Takaful as an industry is as much a scaled version of mutual help as prudent management of the funds.  

How does Takaful compare with conventional insurance?

Conventional insurance sees policyholders pay a premium in exchange for payout to a beneficiary in case of the policyholder’s death. Term insurance covers a certain time period and, in the absence of a claim during this period, the premiums remain with the insurer. A whole-of-life policy has a monetary value since the bulk of the premiums cash is invested and can see some of this investment drawn down within certain parameters. It is useful to understand how Shari’ah finance views this conventional structure and the relevant terms, before then diving into the Ins and Outs of the Shari’ah Takaful:

• ‘Riba’ (interest) – interest is banned in all forms of Shari’ah finance. It is judged to appear in two guises in conventional insurance: firstly, a payout far larger in value than the premiums paid is deemed to be profiting from money directly; secondly, the invested premiums in the case of whole-of-life could be in interest-bearing investments.
• ‘Gharar’ (uncertainty) – though insurance itself deals with the great unknown, in this case, it refers to the uncertainty of liability for the counterparties. Either: “I pay you, Mr Insurer, and you gain when no claim is made, or I do claim and you pay me a big amount?” We just don’t know, and this is ethically unacceptable to Shari’ah.
• ‘Qimar’ (a type of inequality) – as an extension of ‘Gharar’, one party gains at the expense of the other. Which doesn’t fit with the general Shari’ah finance principles of shared risk, responsibility and gain.
• Maisir’ (chance/risk) – premiums are paid (invested), but the return (payout) is not based on any plan. There’s a hint of the speculative.

With conventional insurance, the investment agent is paid out of the premiums received. In the Takaful structure, the agent works for the company itself, and so is paid by the company. Takaful providers insist that the overall cost of a life policy under this structure is cheaper than conventional insurance. A counter-argument is that there is less flexibility on the underlying investment portion since the funds invested in must be compliant too, narrowing the usual fund platform of options to which insurers have access.

The Takaful alternative to conventional insurance

While the most common Takaful life cover structure is called Wakalah, which we’ll describe here, Takaful itself is distinct due to how the incoming cash is treated. Premiums received by the insurer are split three ways:

1. The majority is paid into what’s called Waqf, which is the common pool from which the claims of other members are paid. A Waqf is set up by the shareholders of the Takaful providers. Part of the Waqf money – usually about 25% is considered a donation – you’re paying to essentially aid another without recompense, which doesn’t affect the fact that you can claim from it if needed. This part of the Waqf money is what you might call the ‘protection’ part.
2. The rest of the Waqf then flows to an investment structure managed by someone appointed.
3. The third part is paid as a management fee to the Takaful provider, who might also get a share of the UnderWriting Surplus (UWS – essentially the extra in the kitty over and above requirements due to prudent management).

Beyond claims, policyholders get a kind of windfall from their participation in two ways:

1. Receiving a share of the profits of the investment proceeds (ie, not the money that stays in Waqf, which is the donation) either during, or at the end of, their policy term.
2. The net rest of the underwriting surplus (with of course nothing paid out if there’s an underwriting loss – where less is in the pot than what is required to operate efficiently).

The Wakalah model is more common in the Middle East than the Mudarabah model practised more in Asia (which has a different structure in the relationship between manager and policyholders).  

Takaful – Verdict

As an expat in the UAE looking at life insurance options, Takaful is definitely worth discussing with your IFA. It does work differently to conventional insurance in many ways, but the basic idea that you make payments and then receive payment when in need is central to both. Takaful definitely offers a clearer ethical perspective than normal insurance – as well as potentially saving clients money.