Islamic Finance: Modus operandi of a takaful company

After having understood the concept of takaful last week, it will now be in order for us to learn the modus operandi of a takaful company.

Difference between takaful and insurance set-up: Various functions and processes of a conventional insurance company, such as marketing, advertising, underwriting, reinsurance, processing claims, making investments, maintaining accounts, company management, etc are also found in a takaful company.

Nevertheless, with the difference, all these functions are fully compliant with Sharia code of conducting the business.

Though at present the takaful industry is considered to be in its infancy, great strides have been made to provide an alternative to most of the products and services marketed by the conventional insurance industry in the modern age.

For example, takaful companies can now offer cover for marine, fire, theft, motor, accident, aviation, engineering, etc. In addition, life insurance is also provided under the umbrella of takaful.

Due to the fact that takaful products are Sharia-compliant in nature, these risks can be countered at prices and terms more competitively than the conventional insurance. How?

Because the Sharia scholars are averse to the idea of over-estimating the risk premium - a common practice in conventional insurance field - besides the unique practice of re-distributing the net surplus, as defined later in this article.

How does takaful work?

We have learned, takaful means guaranteeing each other or standing for each other. Truly demonstrating this spirit, takaful participants (policyholders) enter into a contract (policy) with the company declaring that they are contributing financially (premiums) towards a collective risk-taking scheme (takaful fund) whereby if a pre-defined loss (claim) is caused to a participant, it will be met out of the takaful fund comprising their individual contributions.

Takaful fund is managed by the company on the principle of mudaraba (fund management), as per the 'partnership' clause in the contract.

You might recall that in an earlier article we had discussed that a mudareb (entrepreneur) utilises his expertise in handling an investor's funds with an aim to generate profit, which is then shared between them at a pre-agreed ratio.

However, the mudareb is not responsible for the loss, unless it is caused by his own negligence in which case he will be responsible to return the invested amount along with the anticipated profit to the investor.

Takaful clause clearly stipulates the rights and obligations of the participant vis-a-vis the company on the same mudaraba rule. Based on its expertise, the company, acting as an entrepreneur, defines various classes (risks) of takaful and the contribution rate (premium) applicable to each of them.

Determination of the rate for each class is based on various cost factors, mainly the re-insurance cost and the operational expenses. As stated above, Sharia scholars prohibit the company to over-estimate the risk premium in order to be fair with the participants.

Hence, takaful premiums should generally be lower than the ones charged by the conventional insurance operators. We will learn the terminologies as we proceed. Please note that the premium is called 'tabarru', literally meaning donation.

General takaful fund made up of various tabarru payments is invested in accordance with Sharia principles. Due to non-availability of many Sharia compliant investment channels and exercising extreme caution, takaful companies usually find it convenient to place most of the fund amount with Islamic banks.

Profits earned from the investments are pooled back to the fund. On the other hand, compensations (claims) are paid out to suffering participants from the same fund. In addition, fund is also charged for re-insurance costs and all administrative and operational expenses.

Though not a Sharia requirement, many takaful companies do create a reserve account as a matter of precaution to meet with the unforeseen losses to the participants.

The most interesting and attractive part of takaful operation from a participant's point of view is the re-distribution of the net surplus achieved by the company upon completion of its operating cycle. The net surplus is arrived at after meeting all costs, claims and expenses and the allocation to the reserve account.

In accordance with the mudaraba principle, the net surplus is shared among participants and the company as per a pre-agreed ratio. However, Sharia scholars agree that the participants, who had suffered losses and were paid out of the fund, do not have a right to share the surplus since they already stand compensated.

The following example will make it quite convenient to understand the mode of takaful operation:
Say, the participants (policyholders) of the fire risk contribute Dh10 million as tabarru in a particular year to a company called 'Ittihad Takaful'.

The net-surplus sharing ratio between participants and Ittihad was agreed at 80:20. The company will keep the amount in a special account to be called Ittihad fire takaful fund which will be administered by the company as modareb, on behalf of the participants.

Let us assume that the following statistics appear in Ittihad's year-end audited accounts concerning the above fund: Thus, it could easily be derived from the above data that according to the pre-agreed sharing ratio, participants will receive Dh800,000 whereas Ittihad takaful will retain Dh200,000 as their respective share from the net surplus achieved at the year-end.

Elaborating it further, if a participant had paid tabarru amounting to Dh10,000 at the start of takaful period, he will receive back Dh800 upon completion of the period. This translates into a return of eight per cent per annum on a payout considered pure expense in the field of conventional insurance.

Please note that this is simply an example and that higher returns could be achieved, depending upon the magnitude of the net surplus in a particular year. Similarly, it is important to note that in the event of higher compensation paid to the participants, the takaful holders may also be asked to contribute additionally towards meeting the shortfall.

However, such insta-nces could be rare due to re-insurance cover obtained by takaful companies, reserve build-up and the large number of participants.

In addition to general takaful, a person can also participate in family takaful scheme. In this scheme, the participant pays the takaful installment for an agreed period of time. The amount of each installment is then divided and credited into two separate accounts namely 'The participant's account' and the 'the special account'.

Major portion of the installment amount (say 90-95 per cent) is credited to the participant's account and the balance goes to the special account.

Upon completion of the period, the amount collected in participant's account is returned to him, togeth