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Islamic finance requires accurate vocabulary

Otherwise inaccurate terminology misleads people regarding the true economics of Islamic finance transactions.

Posted 12 November 2018

For many years I have been unhappy with the name (in English) many Islamic finance practitioners give to the payment made by a customer under a takaful (Islamic insurance) contract.

It is often described as a "donation" when it is nothing of the sort. Such terminology risks misleading people who are new to Islamic finance regarding the true economics of the transaction.

I made this the subject of my September column in the magazine Islamic Finance News.

Islamic finance requires accurate vocabulary

Many people encountering real world Islamic finance for the first time experience disillusionment. For example, they hear Islamic finance evangelists wax lyrical about its profit sharing basis, but are then dismayed to find that the overwhelming majority of Islamic banking uses fixed return contracts such as murabaha and ijara.

One of my particular concerns is the language often used to name the payment made to a takaful fund by a customer who is seeking protection against a risk.

With conventional insurance, I pay an insurance premium to an insurance company. In return, the insurance company promises to pay me specified amounts of money if my house experiences fire damage in the next 12 months. Shariah scholars consider conventional insurance prohibited for two reasons:

  1. The insurance company hold the premiums received, and invests them until claims need to be paid, typically buying impermissible investments such as interest-bearing bonds.
  2. TheĀ  regard my contract with the insurance company as containing a prohibited level of uncertainty. (“Gharar” in Arabic.) If my house burns down in the next year, I receive far more from the insurance company than I paid in my insurance premium. If my house does not burn down during the year, I receive nothing from the insurance company.

Conversely, Shariah scholars approve of takaful for risk protection. Obviously, takaful companies do not buy prohibited investments such as interest-bearing bonds. More importantly, the equivalent uncertainty in a takaful contract (I receive a large amount from the takaful company if my house burns down) is permissible because underwriting surpluses arising in the takaful fund belong to the takaful participants, and collectively in the long run they bear any underwriting deficits. Shariah scholars refer to this as the principle of “tabarru” in Arabic.

When writing in English, Shariah scholars often translate “tabarru” as “donation” or “gift.” That is the point at which their vocabulary becomes inaccurate, indeed in my view grossly misleading.

English, a donation is something given freely and with no requirement for any reciprocation. A payment into a takaful fund can never be accurately described as a donation. If you pay into the fund, you get compensated if your house burns down in the next year. If you do not pay, you do not get compensated if your house burns down.

A much less misleading description is to call it a takaful contribution, since in English there is no presumption that contributions are gratuitous. Most accurate of all would be to call it a takaful premium, just as premiums paid to insurance companies are called such irrespective of whether the insurance company is a proprietary company or a mutual company, which is the conventional analogue of takaful (apart from the fact that conventional mutual insurance companies still invest in interest-bearing bonds and other impermissible investments.)

Calling the payment a takaful premium would make it as clear as possible that the economic function of a takaful company is the same as the economic function of an insurance company. Namely, to enable people who cannot afford to bear the uncertainty of a large, potentially catastrophic, risk (such as my house burning down) to remove that risk from themselves by paying a much smaller amount of money each year and in return receiving compensation if the unwanted event (the house fire) materialises.

Correspondence with a very knowledgeable reader

Ajmal Bhatty has long experience of the takaful industry. He posted a comment using the Disqus comments facility below, to which I responded, and in turn he responded further. Due to a technology problem I cannot presently resolve, the comments have disappeared below, even though I can still see them in my Disqus administration account.

Accordingly, I have copied them below.

Ajmal Bhatty 16 November 2018 at 08:48

Fully agree with the notion that vocabulary used in Takaful (and Islamic Finance) can be misleading and should be reviewed and changed to make it simpler and easier to understand.

Regarding takaful, actually it is not "donation" but "contribution" that is used in most of the literature. Wherever it is not, it should be changed to contributions. The underlying concept is that of donation, which many question, but it is to conceptually minimise semblance of gambling through the mutuality aspect for collective protection. This reflects a unilateral arrangement where the insured jointly participate in a pool rather than a bilateral arrangement of buying protection from insurance company for which a premium is charged in conventional insurance. Hence the term "premium" is not used.

Mohammed Amin 16 November 2018 at 15:23

Thank you for this response.

I appreciate that you will have seen far more takaful literature than me. However I have seen far too many people referring to “donation” or the “donation principle” which is why I wrote the piece.

In my opinion, leaving to one side how the funds are invested, the boundary between takaful and conventional insurance is not as rigid as some represent.

For example:

1) With takaful sometimes the operator is allowed to share in underwriting surpluses.

2) in conventional mutual insurance, actuarial surpluses belong to the future insurance customers, in a very similar manner to takaful.

In my view, “takaful premium” is the most appropriate terminology for the payment by the customer into the takaful pool. The main thing the customer is paying for is risk transfer, as with conventional insurance, whether the insurer is proprietary or a mutual. The terminology should seek to describe the economics as accurately as possible.

The religious analysis is of course up to the individual Muslim since each of us is individually accountable to God.

Ajmal Bhatty 24 November at 06:24

Whilst I don't have strong views against the use of "premium" in takaful terminology, I can see the logic of making this distinction by calling it "contribution" to underline the concept of mutuality amongst the insured in takaful, away from the domain of takaful shareholders. There is this difference between takaful and conventional insurance, which to a lesser extent, but is still there between a conventional Mutual and a conventional Proprietary insurer.

Let me explain this more in reference to your points:

1. Surplus is sometimes allowed or not allowed according to the recognised contracts and stipulations and depending on which model is followed. There is a lack of global standardisation which is very much needed to make it simpler and easier for people and industry to follow, to enable takaful to grow with better market penetration and better financial management. There are various models where the sharing of surplus between participants and shareholders is either allowed (e.g., Malaysia within stipulated rules, and Saudi Arabia) or not allowed.(e.g., most other countries follow the rulings of Shariah scholars, stipulated as AAOIFI standards ... Accounting & Auditing Organisation of Islamic Financial Institutions).

My views are that takaful is mutual at the insured level, within the cooperative relationship between customers and shareholders. Hence the underwriting surplus ought to be shared between them according to stipulated rules and guidelines driven by actuarial assessment for financial sustainability.

2. Conventional mutual insurance sets aside actuarially determined surpluses for distribution to its customers, for both existing and future customers. This is the same in takaful, for all types of products... protection products or savings as insured risks remain mutual at customer level (no notional risk transfers to the company/shareholders). This is distinct from conventional proprietary companies where "premiums" represent price of risk that the shareholders are exposing their capital to. The risk is transferred from customers to shareholders. The shareholders "own" all funds and reserves and offer the "promise" to pay the clams if these happen. If no claims take place then that portion of "risk" fund contributes to shareholder profits. No surplus is given to the customers (as distinct from with-profit and savings products which contractually pay returns and bonuses etc). There are complex matters in takaful where deficits in customer funds (due to excess claims etc) are corrected by interest free loans from shareholder funds to be repaid from future surpluses of customer funds but if these deficits continue then such loans remain outstanding which effectively means the risk is shared by shareholders without any compensation (which sounds like a risk transfer). But this I leave for another debate.

Takaful of course emanates from religious edicts against conventional insurance and hence there was the need for takaful within the Shariah principles. These principles are good for society generally, not just for Muslims, and form part of the ethical finance eco-system of shared values for the common good of all.


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