Takaful - an introduction

Published by Kim Durniat on

Our expert

  • Kim Durniat

    Kim Durniat

    Partner and Head of Life Consulting

  • Lloyd Richard contributed to the writing of this blog

    Issues surrounding Islamic Finance and in particular Sharia-compliant investment have recently penetrated the public consciousness through the advent of Auto-Enrolment, with NOW:Pensions' recent u-turn on the subject meaning that all three of the major Auto-Enrolment providers now offering sharia-compliant funds to their members. As with investment, certain restrictions also exist for Muslims seeking to purchase insurance.

    Sharia Law

    Muslims are subject to Islamic Law known as the Sharia.  In the case of Islamic finance there are three specific activities which are prohibited:

    'Surplus without value', primarily the charging of interest (Riba) Ownership depending upon the occurrence of a previously defined uncertain event (Maysir) Gambling or speculative transactions (Gharar)

    A further element of Islamic Finance is that firms cannot deal in business that is considered to be sinful (Haraam).  Examples of this include businesses which deal with pork, alcohol, firearms, etc.


    With regards to basic financial transactions, profit is permissible via the “honest declaration of profits” (Murabahah).  This is the where the seller clearly states how much they bought the product for alongside the price they are selling it at.  Both parties agree to this prior to the transaction thus making it transparent and permissible.  In the example of a mortgage, the lender would purchase the house on behalf of the buyer and sell it to them over time with profit margins clearly stated.  On default, the current standing of ownership proportions would be maintained as opposed to repossession.

    When it comes to lending money, instead of offering a loan and charging interest, firms partake in Profit Sharing (Mudarabah) or Joint Ventures (Musharakah).  In the case of Profit Sharing, the lender and borrower agree on what value of profits earned are given to the lender whereas in Joint Venture, both parties have control over the business and thus share a proportion of the profits.

    With the above concepts in mind, a solution for Sharia-compliant insurance is the takaful model.  What follows is an outline of how it works and the current market.

    How it works

    The classic takaful model prior to the 1970s simply involved members donating to a fund with the intention of supporting each other.  There was a clear definition of what was to be paid and what was compensated, with losses being divided amongst members.  This rather simple model worked well when consisting of only a handful of members however it wasn’t scalable.

    Modern takaful involves a takaful operator which is the administrator of the fund and manages it in trust on behalf of members.  The two main models for modern takaful are the Mudarabah Model and the Wakalah Model.  In both models, the policyholders make donations to the fund and the takaful operator provides its expertise to operate the business.  Under the Mudarabah Model, the takaful operator takes a share of the profits or alternatively stands to lose the value of its time and effort in the case of a loss, however it does not explicitly share the cost of any loss which may occur.  The Wakalah Model on the other hand involves the takaful operator charging a fee for services rendered.

    Policyholders’ contributions are considered to be donations to a pool, from which losses are divided and liabilities spread to help those who need assistance.  Uncertainty with regards to subscription and compensation are eliminated by clearly defining agreements, and no advantage is derived by the operator at the expense of others.

    Structure of the Mudarabah Model  and Wakalah Model (right)

    There are many parallels to the mutuals sector, not least the shared foundations of encouraging co-operation and mutual support. Both operate without shareholders, so any surplus is returned to members, resulting in pooled funds that are run by members for the benefit of members. The key difference between a Mutual and takaful is what investments are permitted, as some conventional investments may be considered speculative or unethical.

    Mutual insurance originated in the UK in the 17th century to allow neighbours to pool resources against the risk of fire damage, and the fundamental characteristics of takaful are based on several Qur’anic verses concerning responsibility and shared protection: “One true Muslim and another true Muslim are like a building, whereby every part in it strengthens the other part.”

    The Takaful Market

    The key markets for takaful are the Middle East, the Persian Gulf states, Indonesia and Malaysia, where annual takaful donations make up as much as 40% of total insurance premiums. Admittedly, insurance penetration in these areas is low compared to the West. In 2010, worldwide takaful donations amounted to around $13.7 billion, compared to $4.3 trillion total insurance premiums globally. However, Islamic finance is growing at an astonishing rate, and given the size of the Muslim population and the clear appetite for sharia-compliant financial products this suggests a strong capacity for growth in non-commercial insurance arrangements.

    The need for such products is not limited by geography. I started this blog by noting that the three Auto-Enrolment pension providers have determined the need to provide sharia-compliant investment funds for their members. This would suggest that consumer demand for Islamic finance exists, although takaful has so far failed to find traction in Europe. This may be caused by a lack of an independent certification committee who can offer reassurance that products marketed as compliant truly are; akin to the strict HCC rules for halal food.

    At present, the only UK takaful operators are focused on niche markets, but some of the world’s largest conventional reinsurers have begun to provide retakaful facilities, including Mitsui Sumitomo, Swiss Re and Hannover Re.  Retakaful is essentially a sharia-compliant version of reinsurance, working in the same way as a takaful arrangement for the same reasons a commercial reinsurer would enter into a reinsurance arrangement.

    The use of such products does not need to be limited by faith either. In Malaysia, for example, the main purchasers of Islamic financial products are non-Muslims who are attracted by the ethical appeal and their mistrust of commercial finance. In Turkey, strict secular rules force takaful products to be marketed as “ethical and cooperative” rather than sharia-compliant, and policyholders have a diverse range of religious beliefs. With an established market of friendly societies and mutual insurers the UK is perhaps a natural domain for Islamic finance’s wider ethical appeal.

    Takaful is undeniably an established part of the global insurance market with strong capacity for growth. Whether it will reach its full potential cannot be answered simply, but it remains worth watching.