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Accounting, Auditing and Governance for Takaful Operations

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Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offi ces in North America, Europe, Australia, and Asia, Wiley is globally committ ed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding.

Th e Wiley Finance series contains books writt en specifi cally for fi nance and investment professionals as well as sophisticated individual investors and their fi nancial advisors. Book topics range from portfolio management to e-commerce, risk management, fi nancial engineer-ing, valuation, and fi nancial instrument analysis, as well as much more.

For a list of available titles, please visit our website at www.WileyFinance.com.

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Accounting, Auditing and Governance for Takaful

Operations

Sheila Nu Nu HtayMohamed Arif

Younes SoualhiHanna Rabittah Zaharin

Ibrahim Shaugee

John Wiley & Sons Singapore Pte. Ltd.

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Copyright © 2013 by John Wiley & Sons Singapore Pte. Ltd.

Published by John Wiley & Sons Singapore Pte. Ltd., 1 Fusionopolis Walk, #07–01, Solaris South Tower, Singapore 138628

All rights reserved.

No part of this publication may be reproduced, stored in a retrieval system, or transmitt ed in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as expressly permitt ed by law, without either the prior writt en permission of the Publisher, or authorization through payment of the appropriate photocopy fee to the Copyright Clearance Center. Requests for permission should be addressed to the Publisher, John Wiley & Sons Singapore Pte. Ltd., 1 Fusionopolis Walk, #07–01, Solaris South Tower, Singapore 138628, tel: 65–6643–8000, fax: 65–6643–8008, e-mail: [email protected].

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best eff orts in prepar-ing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifi cally disclaim any implied warranties of merchantability or fi tness for a particular purpose. No warranty may be created or extended by sales representatives or writt en sales materials. Th e advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor the author shall be liable for any damages arising herefrom.

Other Wiley Editorial Offi cesJohn Wiley & Sons, 111 River Street, Hoboken, NJ 07030, USAJohn Wiley & Sons, Th e Atrium, Southern Gate, Chichester, West Sussex, P019 8SQ, United KingdomJohn Wiley & Sons (Canada) Ltd., 5353 Dundas Street West, Suite 400, Toronto, Ontario, M9B 6HB, CanadaJohn Wiley & Sons Australia Ltd., 42 McDougall Street, Milton, Queensland 4064, AustraliaWiley-VCH, Boschstrasse 12, D-69469 Weinheim, Germany

ISBN 978-1-118-50395-9 (Paperback)ISBN 978-1-118-50397-3 (ePDF)ISBN 978-1-118-50398-0 (Mobi)ISBN 978-1-118-50396-6 (ePub)

Typeset in 11/14 pt, Arno Pro by MPS Limited, Chennai, India.Printed in Singapore by Markono Print Media.

10 9 8 7 6 5 4 3 2 1

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Contents

Foreword ix

Preface xi

Acknowledgments xv

1 Introduction to Takaful and Retakaful 1

Learning Outcomes 1Introduction 2History of Insurance and Takaful 2Differences between Takaful and Conventional Insurance 4Shariah, Legal, and Regulatory Framework of Takaful 7The International Association of Insurance Supervisors (IAIS) and

Islamic Financial Services Board (IFSB) 13Different Types of Takaful Models 14An Overview of Retakaful 22Conclusion 31Chapter Questions 31Notes 31References 32

2 Takaful Companies and Their Accounting Environment 33

Learning Outcomes 33Introduction 34The Concept of Accounting in Business

and Its Historical Development 34

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vi / CONTENTS

Malaysian Accounting Environment 35International Accounting Standard Setting Bodies 48Malaysian Insurance Institute 49Conclusion 50Chapter Questions 50References 50

3 Prevailing Accounting Standards and Accounting Entries for Takaful Operators 53

Learning Outcomes 53Introduction 54Guidelines on Financial Reporting for Takaful Operators 54AAOIFI FAS 12: General Presentation and Disclosure in the Financial

Statements of Takaful Companies 55AAOIFI FAS 13: Disclosure of Bases for Determining and

Allocating Surplus or Defi cit in Takaful Companies 58AAOIFI FAS 15: Provisions and Reserves in Takaful Companies 59AAOIFI FAS 17: Investments 61AAOIFI FAS 18: Islamic Financial Services Offered by

Conventional Financial Institutions 62AAOIFI FAS 19: Contributions in Takaful Companies 62Accounting Entries 63Conclusion 99Chapter Questions 99References 102

4 Financial Statement Analysis 103

Learning Outcomes 103Introduction 104Financial Ratios for General Takaful Funds 104Financial Ratios for Family Takaful Funds 107Financial Ratios for Shareholders’ Funds 110Conclusion 113Chapter Questions 113References 113

5 Zakat Computation and Distribution for Takaful and Retakaful Companies 115

Learning Outcomes 115Introduction 116Zakat and the Islamic Worldview 116Zakat Computation Methods (AAOIFI) 120Suggested Disclosure Information 122Conclusion 123Chapter Questions 123Notes 123References 123

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CONTENTS / vii

6 Auditing and Governance for Takaful Operators 125

Learning Outcomes 125Introduction 126An Overview of the Auditing Standards 126Suggested Guide for Shariah Audit 128Practical Implementation 129Governance for Islamic Finance 136Conclusion 151Chapter Questions 152References 152

Appendix 1: Sample Audit Proposal 155

Appendix 2: Audit Plan Timeline 167

Appendix 3: Audit Program 169

Appendix 4: Report on Shariah Compliance Audit for Takaful X Sdn. Bhd. as of 31 March 2011 171

Contents 1721. Executive Summary 1732. Aims and Objectives 1773. Background/Introduction 1784. Shariah Audit Methodology 1825. Shariah Audit Findings and Result 183

About the Authors 197

Index 199

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Foreword

Th e establishment of an Islamic bank in Malaysia, in the early 1980s, generated signifi cant inter-est in the populace for an institution that would fulfi l a prevailing need for an alternative to conventional insurance in order to complement and supplement the insurance needs of Islamic banking. Th is interest, coupled with a fatwa declaring conventional insurance as a void contract due to its Shariah -noncompliant elements, issued by the Malaysian National Fatwa Council in 1972, prompted the government to establish a working team of Islamic scholars, legal experts, and insurance practitioners, called the “Special Task Force to Study the Incorporation of an Islamic Insurance Company in Malaysia.” I was aff orded the privilege of serving as a member of the Task Force. Arising out of the recommendations of the Task Force, a Takaful Act was enacted in 1984 and the fi rst takaful operator was incorporated in November 1984.

Since its inception the Malaysian takaful industry has seen monumental growth, from a single entity with relatively limited products, to one that is well integrated into the mainstream fi nancial system. Over the years the industry has registered double-digit growth constantly, and has proven to be extremely resilient despite the intense competition from a well-established, well-fi nanced conventional insurance sector, as well as economic upheavals. Th e eff orts of the takaful operators as well as Bank Negara have to be commended. It was these resolute eff orts that made the achievements of the Malaysian takaful industry possible.

As a person who built its foundation and had been working in the Malaysian takaful industry for more than two decades and seen its development fi rst hand, I cannot help but feel extremely proud—proud not only of the phenomenal growth the industry has already achieved but mostly of the fact that takaful keeps on growing by leaps and bounds, pointing to an extremely bright future. However, in our pride we should not ignore the challenges facing the industry.

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x / FOREWORD

One such challenge is talent development. To maintain such rapid growth the industry demands adequate supplies of knowledgeable and competent human talent. Th e operators are constantly on the lookout for human talent that would take the industry to the next level.

Malaysia has medium- and long-term plans to develop this requisite human talent. A key component of these plans is academic programs off ered by various educational institutions. For these programs to be successful, proper materials, including books, are needed. Lack of books and writings on takaful was a key challenge that we faced during the initial development of taka-ful . Today this is not so. Th ere are a number of books available on takaful . However, there is still a noticeable lack of books on specialised areas of takaful —accounting and auditing are two such areas. As such, this book is not just another book on takaful . It does fi ll a gap. It is writt en in a language that is straightforward and easy for an average man to understand, and at the same time avoids oversimplifi cation that might put off professionals. Th is book provides a one-source alternative for knowledge of every aspect of takaful operations—from the basic principles to accounting entries. I take this opportunity to thank the authors for their eff orts in writing this book, which I am sure will form a must-read for anyone interested in takaful . May Allah make this eff ort a success and bless their future endeavours.

Dato’ Mohd Fadzli Yusof

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Preface

What started as a search by Muslim scholars and political economists for an alternative to the economic and fi nancial system forced upon the Muslim world aft er their colonisation has today developed into a thriving industry that has witnessed rapid evolution and expansion within the past decade. Th is is visible not only in the Islamic world but in the Western world as well, signify-ing its robustness and vigor in the face of the fi nancial crises that rocked the major economies of the world. It is no longer a product off ered to a niche market but a genuine fi nancial alternative with presence in more than 60 countries of the world with assets worth billions of dollars.

What started as a collection of mostly banking institutions has evolved into a comprehen-sive system consisting of a robust takaful (Islamic insurance) sector as well as other nonbanking fi nancial institutions. While the success of Islamic fi nance is typically signifi ed by the number and strength of Islamic banking institutions, the role of takaful should not be underestimated. Th e suc-cess and development achieved by the takaful sector is especially impressive when it is placed in the context of insurance penetration rates in Muslim countries, which typically tend to be very low.

In contemporary times, Islamic fi nance is considered one of the fastest-growing areas of international fi nance. Th e span of Islamic fi nance and takaful is growing remarkably fast not only in the Gulf region but also in non-Muslim countries. Expansion in the takaful business has been robust in recent times.

Th e demand for takaful and diff erent takaful products is quite strong and consequential. Islam is the fastest growing religion and constitutes the second largest religion in the world. Present era Muslims are looking for religion-based solutions to the problems they face.

Th e achievements of the takaful sector and the potential for future growth, underlined by increasing affl uence and positive demographic changes, paint a very positive picture of the

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xii / PREFACE

future for the industry. To reach its potential, the sector has to be anchored on stable institutional foundations—none more important than human capital. Institutions such as the IIUM Institute of Islamic Banking and Finance (II i BF) have already put in place robust programs to develop talents that would take the Islamic fi nance industry to the next level. Th is book is aimed at pro-viding proper material that can be used as a part of academic curriculums of such a program.

A comprehensive curriculum needs to address each and every aspect of the program and needs to be supplemented by easy-to-get references, including textbooks. While there currently are a multitude of books on Islamic fi nance in general and takaful specifi cally, there seems to be a lack of texts on the accounting and auditing aspects related to takaful. Th is book is aimed at fi ll-ing this gap. It is hoped that this book can help guide the educational journey of students inter-ested in takaful as well as act as a useful reference guide to accounting and auditing practitioners in the takaful sector and the Islamic fi nancial industry at large.

About the Contents Chapter 1 is presented as an introduction to takaful (Islamic insurance). Th rough the discus-sions in this chapter, the reader should be able to grasp a basic understanding of the history and development of conventional insurance as well as takaful . Th is discussion also encompasses the diff erences between these two concepts. Furthermore, this chapter also explains the Shariah , legal and regulatory framework behind takaful operations, as well as the basic takaful models being practised around the world.

Chapter 2 focuses on accounting and its relationship with takaful operators. Th is chap-ter starts out with a brief explanation of what accounting is and how it was developed. Aft er that, the discussion is aimed at providing a brief look at the operating environment of takaful operators—specifi cally the accounting and governance aspects. Th is includes the accounting and governance standards and guidelines as well as the organisations that set them. Th e discus-sion in this chapter is mostly focused on the standard-sett ing organisations and institutions.

Chapter 3 provides a detailed look at the fi nancial reporting requirements of a takaful operator. Th e emphasis of this chapter is mostly on the requirements of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) standards for takaful opera-tors. Furthermore, this chapter also provides typical journal entries that a takaful operator has to pass in order to record its transactions, including retakaful.

Chapter 4 discusses fi nancial statement analysis. Th e discussion is from the perspective of a takaful operator; hence, it is diff erent from a typical fi nancial statement analysis. Th e ratios discussed in this chapter include underwriting, profi tability, as well as liquidity ratios. Th e ratios are grouped according to the source of funds—general takaful fund, family takaful fund, and shareholders’ fund. Readers should be able to calculate the ratios as well as describe the results and make sense of the fi nancial statements of a takaful operator aft er reading this chapter.

Chapter 5 focuses on zakat —computation and distribution—for takaful operators. Th e discussion starts with an introduction to zakat and its relationship to the Islamic worldview. Aft er that, the discussion moves on to zakat computation for takaful operators. Th e discussion

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PREFACE / xiii

here is based on the methods suggested by the AAOIFI. Aft er discussing computation, the chap-ter ends with a look at the disclosure requirements as suggested by the AAOIFI.

Chapter 6 provides a detailed look at the auditing and governance standards that a taka-ful operator has to follow. Th e standards discussed include those set by the AAOIFI, the Islamic Financial Services Board (IFSB), Bank Negara Malaysia (BNM), and Bursa Malaysia.

Background and Readership Th is book is intended as an introduction to accounting, auditing, and governance issues related to takaful operations for students, practitioners, and the general public who may be interested in the inner workings of the takaful industry. With this readership in mind, the book has been writt en in such a way that a reader would have no diffi culty understanding the content. Special care was given to ensure that less technical jargon was used and that the language was kept as simple as possible. Similarly, with the potential dryness of the subjects being discussed in mind, every att empt has been made to keep the discussion interesting through the use of easy-to-understand examples and fi gures.

Although the book is seen as an introduction to accounting, auditing, and governance issues related to takaful operations, we have assumed that readers will be acquainted with the very basic concepts of Islamic fi nance. As an integral part of the burgeoning Islamic fi nance land-scape, proper understanding of takaful requires an understanding of Islamic fi nance. Despite the importance of Islamic fi nance as a theoretical foundation for the issues being discussed in this book, it is not within the scope of this book to discuss those principles.

Relationship with Other Books While a large number of books have been writt en on Islamic fi nance and to a slightly less degree on takaful , books concentrated on accounting and auditing for takaful operators are extremely limited. Although takaful is unique as a product and industry, students and practitioners cur-rently do not have any references on accounting and auditing techniques, principles, and proce-dures applied and used by takaful operators. Th e only alternative they have is to rely on books writt en on accounting for insurance companies. However, the unique nature of takaful makes this an unsatisfactory compromise. While students and practitioners do have limited books on accounting for Islamic fi nancial institutions available for reference, the institutions focused on in these books are mostly banks and other similar institutions. Th erefore, this book is targeted at fi lling this gap.

While the writers view the material related to accounting and auditing presented in this book as mostly unique, the reader can refer to a number of other books to gain knowledge of basic Islamic fi nance concepts to act as a foundation and, at the same time, to enhance their understanding of basic takaful principles and operations discussed in this book.

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Acknowledgments

In the Name of Allah, Th e most Gracious, Th e most Merciful. All praises and thanks to the Almighty Allah (SWT) and peace and blessings are upon

our beloved Prophet Muhammad (SAWS), his family, and his companions. Whose patience and steadfastness in hard times stand as a model for humanity.

First and foremost, we would like to thank and praise Allah for blessing us with the ability and perseverance to complete this book. For without His blessing and mercy, this book would not have seen the light of day.

Th e mission of organising this book has been deeply facilitated by the sincere assistance and encouragement of many persons, who have contributed directly or indirectly towards this eff ort. It is our obligation to acknowledge these contributions and thank them.

Sincere and special thanks are due to Wan Zamri Wan Ismail, consultant ( takaful ), fi rst international consultant (FIC). His assistance, encouragements, and cooperative behaviour were instrumental in the completion of this book.

Furthermore, our deepest thanks to Mr. Mustapha Hammat (Distinguished Fellow, Institute of Islamic Banking & Finance, IIUM) and Dato Professor Dr. Mohd Azmi Omar (Director, Islamic Research and Training Institute) for their kind support, assistance, and invalu-able guidance.

In addition, we would also like to extend our infi nite gratitude and thanks to all the II i BF staff .

Last but not least, our thanks and appreciation to all those who contributed towards the completion of this book.

May Allah bless and repay their kindness and bestow his blessings on all of you.

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CHAPTER

1

Introduction to Takaful and Retakaful

Learning Outcomes

After reading this chapter, you will have:

1 A basic understanding of the history and development of insurance (conventional insurance) and takaful as well as an awareness of the differences between these two concepts.

2 An understanding of Shariah , the legal and regulatory framework behind takaful , including Shariah principles, legal requirements, and regulatory agencies.

3 Knowledge of the basic takaful models being practised around the world.

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2 / ACCOUNTING, AUDITING AND GOVERNANCE FOR TAKAFUL OPERATIONS

Introduction Although this book is mainly aimed at explaining the accounting treatment for takaful operators, it is important for readers to acquire a basic understanding of the history and principles behind takaful operations in order to fully appreciate the setup of takaful operators. For this reason, Chapter 1 provides a brief history of insurance and takaful as well as a brief look at the principles behind takaful.

History of Insurance and Takaful

History of Insurance (Conventional Insurance)

Conceptually, insurance is a form of risk management primarily used to hedge against the risk of a contingent loss. Insurance is defi ned as the equitable transfer of the risk of a loss from one entity to another in exchange for a premium and can be thought of as a guaranteed and known small loss to prevent a large, possibly devastating, loss. An insurer is a company selling the insur-ance; an insured or policyholder is the person or entity buying the insurance. Th e insurance rate is a factor used to determine the amount to be charged for a certain amount of insurance cover-age, called the premium.

Historically, the Chinese and Babylonian traders practised the early methods of trans-ferring or distributing risk as long ago as the third and second millennia b.c., respectively. A thousand years later, the inhabitants of Rhodes invented the concept of the “general average.” “Merchants whose goods were being shipped together would pay a proportionally divided pre-mium which would be used to reimburse any merchant whose goods were jett isoned during storm or sinkage.” 1 Th e Greeks and Romans introduced the origins of health and life insurance around 600 a.d. when they organised guilds called “benevolent societies,” which cared for the families and paid funeral expenses of members upon death. Before insurance was established in the late seventeenth century, “friendly societies” existed in England, in which people donated money to a general sum that could be used for emergencies. Th e devastating eff ects of the Great Fire of London in 1666 (which destroyed more than 13,000 houses) converted the develop-ment of insurance “from a matt er of convenience into one of urgency.” 2

And modern insurance can be traced back to its beginnings in the 1600s, when British merchants and ship owners began to meet at a coff eehouse near Lombard Street in London, called Lloyd ’s, where they made an agreement to mutually share in the profi ts and losses of sea voyages (Fisher, 2009). It became the meeting place for parties wishing to insure cargoes and ships and those willing to underwrite such ventures. Today, Lloyd ’s of London remains the lead-ing market for marine and other specialist types of insurance. And risk management has evolved as a discrete fi eld of study and practise in the appraising and controlling of risk.

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CHAPTER 1: Introduction to Takaful and Retakaful / 3

History of Takaful (Islamic Insurance)

Takaful is derived from the Arabic word kafalah , which is a pact that guarantees individuals in a group against loss or damage sustained by anyone of them. It is also described as guaranteeing each other or joint guarantee, which encompasses the elements of shared responsibility, joint indem-nity, common interest, and solidarity. Muslim jurists conclude that insurance in Islam should be based on principles of mutuality and cooperation. Hence, Islamic insurance or takaful is a concept of mutual cooperation to guarantee mutual protection of the members. Anchoring the takaful system is tabarru’, which means “donation, gift , or contribution” to be made to the community risk pool. Th is defi ned fund makes takaful free from uncertainty and gambling. Th e purpose of this system is not to generate profi ts but to uphold the principle of “bear ye one another ’s bur-den.” Th e principles of takaful are summarised as follows: (i) As a cooperative insurance, members ( certifi cate holders or participants) contribute a certain sum of money to a common pool so as to cooperate among themselves for a common good; (ii) Every certifi cate holder pays his subscrip-tion with the intention of helping those that need assistance; (iii) Losses are divided and liabilities spread according to the community pooling system; (iv) Uncertainty or gharar is eliminated in respect to subscription and compensation; and (v) It does not derive advantage at the expense of others. Th e objective of takaful is to pay a “defi ned loss” from a “defi ned fund.”

Takaful was established in the early second century of the Islamic era when Muslim Arabs expanding trade into Asia and other continents mutually agreed to contribute to a fund to cover or compensate anyone in the group who suff ered losses through any mishap such as robberies or piracy during the numerous sea voyages. Th e concept of marine insurance had its humble beginnings in this mutual help for those who faced the risk of loss on treacherous sea voyages. In fact, mutual insurance had evolved much earlier under the ancient system of aqila as practised by Arabs of Mecca and Medina. It was based on shared responsibility where payment of blood money or diyyah had to be made by the paternal relatives of the slayer as compensa-tion. Th e doctrine of aqila was approved by the Holy Prophet (SAWS) in a dispute between two women from the tribe of Huzail, which gave continuity to the culture of mutual cooperation and was applied in takaful.

Th e development of takaful in modern times was initially undertaken in Sudan in 1979 followed by Malaysia in 1984. Th e Malaysian National Fatwa committ ee determined that conven-tional insurance is haram due to the presence of the elements of gharar (excessive uncertainty), riba (interest), and maisir (gambling). A special task force was formed by the government to look into the viability of sett ing up an Islamic insurance company. Following its recommen-dations, the fi rst takaful operator (Syarikat Takaful Malaysia Sdn. Bhd.) was incorporated to meet the needs of its Muslim population for a Shariah -compliant alternative to conventional insurance in Malaysia. It commenced operation in 1985. Th e year before, Malaysia gazett ed its Takaful Act 1984. Several takaful operators emerged in the early 1990s providing a healthy com-petition and cooperation among players in this industry. In the early 2000s, the Financial Sector Master Plan (FSMP) was implemented to enhance the capacity of takaful operators in Malaysia as well as to strengthen the legal, Shariah, and regulatory framework to ensure sustainability of the takaful industry.

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4 / ACCOUNTING, AUDITING AND GOVERNANCE FOR TAKAFUL OPERATIONS

As of 2011 there are 10 licensed takaful operators in Malaysia:

1. AIA AFG Takaful Bhd. (foreign) 2. CIMB Aviva Takaful Bhd. (local) 3. Etiqa Takaful Bhd. (local) 4. Great Eastern Takaful Sdn. Bhd. (local) 5. Hong Leong Tokio Marine Takaful Bhd. (local) 6. HSBC Amanah Takaful (M ’sia) Sdn. Bhd. (local) 7. MAA Takaful Bhd. (local) 8. Prudential BSN Takaful Bhd. (local) 9. Syarikat Takaful M ’sia Bhd. (local) 10. Takaful Ikhlas Sdn. Bhd. (local)

Differences between Takaful and Conventional Insurance

Risk Management under Islam

Although Muslims believe in predestination as “only God knows one ’s future and faith,” there is a hadith that sends a strong message to Muslims that they should put in eff ort to reduce the risk of loss before leaving it to God:

Prophet Muhammad (SAWS) asked a Bedouin who had left his camel untied, “Why do you not tie your camel?” Th e Bedouin answered, “I put my trust in God.” Th e Prophet then said, “Tie up your camel fi rst then put your trust in God.”

(Narrated by Al-Tirmidhi and Ibn Majah, Book 60 No. 2517)

Shariah also encourages the practise of spreading the risk among as many people as possible. Th e hadith of Nihd or Ash ’ariyyin is usually quoted to validate this type of risk mitigation in takaful :

Jabir bin ‘Abdillah narrated that “.  .  . then the Prophet (SAWS) dispatched a batt alion along  the coast, appointing Abu ‘Ubaidah bin al-Jarrah as their leader while they were three hundreds including myself. As we reached a certain location, our food fi nished, thereaft er Abu ‘Ubaidah ordered all the food of the batt alion to be pooled, of which mine was dates. Every day he would feed us a litt le food until it fi nished, and then we started gett ing one date each . . .”

(Bukhari)

Although risk management is acceptable in Islam, what distinguishes takaful from conventional insurance is that takaful is a social function of mutual risk-sharing and not a risk-transfer mechanism like conventional insurance.

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CHAPTER 1: Introduction to Takaful and Retakaful / 5

Insurance in Islam

Islam is not against the concept of insurance itself but against some of the means and methods that are currently used in conventional insurance. In fact, the concept of mitigation of risks by adopting the law of large numbers was widely used in Islam and especially in the practise of al-aqilah, the ancient Arab tribal custom. However, to be acceptable in Islam, any form of insur-ance should avoid the elements of riba,’ maisir, and gharar , though elements of gharar may be forgivable depending on the circumstances.

Fatwas Declaring the Illegality of Conventional Insurance

In 1985, the Fiqh Academy of the Organisation of the Islamic Conference (OIC) issued its fatwa  declaring that conventional commercial insurance was forbidden, while insurance based on the application of cooperative principles and charitable donations ( tabarru’ ) was acceptable and Shariah compliant (decision No: 9/[2/9]). Th e Malaysian National Fatwa Committ ee had also issued a fatwa that conventional insurance is haram due to the presence of the elements of gharar (excessive uncertainty), riba (interest), and maisir (gambling). Jurists are unanimous in their agreement that insurance is only permissible in Islam when undertaken in the frame-work of takaful (or mutual guarantee) and ta’awun (or mutual cooperation). Essentially, the con-cept of takaful is based on solidarity, responsibility, and brotherhood among participants. Th e above prohibitions made it necessary for industry players to look for an Islamic substitute or sharia -compliant alternative for conventional insurance.

Fundamental Differences Based on Prohibitions

Rulings by Islamic scholars have declared that conventional insurance as currently practised is unlawful under Islam as it contains elements prohibited under the Shariah , namely, riba , gharar, and maisir. Hence, takaful or the Shariah -compliant alternative to insurance is today governed by the principles of Shariah , where transactions involving riba , gharar, and maisir are eliminated or avoided as illustrated below:

Th e word riba in its literal meaning translates as excess, increase, augmentation, expansion, or growth. Th e technical meaning of it is “every excess in return of which no reward or equivalent counter value is paid.” Th e prohibition of riba is revealed in four stages in the Qur ’anic revelations to show that any form of interest is prohibited under Shariah , and as interpreted by majority of the jurists, whether at a reasonable or an excessive rate. It is the fourth stage that conclusively prohibits all forms of riba : “Allah has permitt ed trade and prohibited usury” and where “any excess over and above the principal amount of capital is disallowed” ( Qur ’an 2: 275–281). Riba is forbidden because it represents a form of fi nancial exploitation where one party to a contract,

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