SHARIAH COMPLIANT SYSTEM FOR RISK MITIGATION

SHABBIR H. KAZMI
June 23 - 29, 2008

Pakistan is emerging as one of the fasted growing market for the Shariah compliant products. With the double digit growth in Islamic banking, there is also enormous growth in other areas i.e. Takaful, Modaraba companies and asset management companies.

Takaful is one of the fastest growing segments of Islamic financial system in Pakistan. One of the reasons is that till recently Islamic banks were forced to accept insurance cover issued by the conventional insurance companies due to absence of Takaful operators.

This handsome growth is mainly due to two facts1) growth of Islamic banking and 2) low insurance penetration in the country. The low penetration has been due to interpretation of religious doctrine that has been widely misunderstood in the context of the financial protection. Given there are almost one billion Muslims in the world, the potential market for Takaful is yet to be tapped. However, as the Islamic banking grows Takaful business is also expected to grow.

To begin with it is necessary to understand Takaful. In the simplest words the Takaful system is based on the principles of fairness, and is committed to serving one another sincerely and truly so that all parties benefit. The uniqueness of this concept is that the underwriting profit is shared among all the participants who have a positive contribution during the year.

The Takaful system of risk hedging consists of various elements that include 1) shariah compliance in Takaful operations and investments, 2) financial and risk sharing under Shariah principles, 3) contributions are in the form of donations or "Tabarru', for mutual assistance to the members of the group and 4) application of ethics and full disclosure.

A Takaful contract is made between two parties but a Takaful scheme normally involves 1) the Takaful operator, providing the service to the community, 2) the participant wishing to have cover against risk of suffering a financial loss resulting from fire, accidents, burglary, death, etc.

For all types of Takaful contracts, the participant has to fill a proposal form to be duly signed by him, which is the basis of the contract. After receipt of the proposal a document mentioning the terms, conditions and the procedure if one suffers loss and wishes to raise a claim on the company for reimbursement is issued.

The Takaful Operator is an organization which manages the Waqf and takes the responsibility of collecting contributions from the participant and to distribute it back to the fellow participants when in need. The operator also manages the investments for the Waqf. The operator charges a fee commonly known as "Wakala fee".

A Waqf (plural "awq?f") is an inalienable religious endowment in Islam. Waqf means putting aside the original property and donating its benefits for the sake of Allah. What is meant by the original property is something from which benefit may be derived whilst its essence remains, such as houses, shops, gardens, etc.

There are three different Takaful models commonly used around the globe. These are 1) Mudaraba, 2) Wakala Model and 3) Waqf Models.

According to the Mudaraba Model surplus is shared between the policyholders and Takaful Operator. The sharing of such profit (surplus) could be according to predefined and agreed ratio mutually agreed between the contracting parties. Generally, these risk-sharing arrangements allow the Takaful operator to share in the underwriting results from operations as well as the favorable performance returns on invested premiums. This structure is commonly used in Malaysia.

As per the Wakala Model cooperative risk-sharing occurs among participants with a Takaful operator charges a fee for services as a Wakeel or Agent but does not participate or have a share in any underwriting results as these belong to participants as surplus or deficit. Under the Wakala Model, the operator may also charge a fund management fee and a performance incentive fee. This is the most commonly used model around the globe.

Under the Waqf Model the contribution given by the participant goes into the Waqf. Thus in the case of any claims the payment is made by the Waqf to the participant. Also, at the end of the year any surplus remaining in the Waqf is returned to the participants who have a positive contribution. This model is commonly used in Pakistan.

Islam does not prohibit individuals from taking measures to cover their financial risk, in fact it encourages it. This is evident from the Hadith of Prophet Hazrat Muhammad (PBUH) in which he told a companion to tie his camel and then put his trust in Allah.

No human action can change the Will of Allah. Whether a person has insurance/Takaful or not has no effect on future events. However, we are instructed to take precautions and then fully trust and depend upon Almighty Allah

In a Hadith narrated by Hazrat Anas bin Malik when an Arab Bedouin asked Prophet Muhammed (PBUH), "Shall I leave my camel untied and seek Allah's protection on it, or should I tie it?" The Holy Prophet replied, "Tie your camel and then depend upon Allah."

All types of risks can be divided into two broader categories 1) pure risk and 2) speculative risk. Pure risk involves the possibility of loss or no loss. For example, damage to property due to fire. Pure risks are the subject of insurance risk protection and Takaful. On the other hand, speculative risk involves the possibility of loss, no loss or gain. For example, venturing into a new business, or gambling on horse race. Speculative risks that include a potential gain or profit cannot be insured.

Takaful schemes use the principle of indemnification to compensate for the loss that occurs to a Takaful participant. Takaful insures only pure risks and the claims only pay in the event of loss to cover repairs, damage, replacement of property, or an agreed fixed sum.

Takaful is not just another tool for risk mitigation and financial protection. Nor, is it just a Shariah compliant business model. Rather, it is an ideology which promotes solidarity and joint guarantee, self reliance and self sustainability for community well being, assistance to those that need it by using community pooling system. In a nutshell, it is a system which works as a source of good for those who use it and the community at large.