Overview
This short white paper gives a concise, high-level outline of the mutual guarantee insurance model, more commonly known in industry as takaful, the Arabic word roughly translating to “mutual guarantee”. Throughout this paper, we will refer to it as the mutual guarantee model (MGM). MGM was originally developed by Islamic financiers as an alternative for the global ~2 billion person Muslim market for whom conventional insurance is religiously forbidden. However, MGM is in no way limited to the Muslim community. In fact, in this paper, we go so far as to argue that MGM provides a more ethical system of insuring assets and risks, void of the uncertainty and gambles posed by its conventional counterpart. We outline what fundamental properties of conventional insurance models make them prohibited in Islam (and how these very properties harm non-Muslims, as well as Muslims), followed by how MGM works to protect policyholders, and finally the roles of the various stakeholders involved in MGM.
Prohibited Elements of Conventional Insurance
The elements of conventional insurance which are forbidden according to Islamic law (and therefore prohibited for its ~2 billion adherents) can be grouped into three categories with minimal overlap:
1. Policy Contract Uncertainty
Upon paying premiums to a conventional insurance carrier those funds effectively enter a blackbox, in which the allocation, investment, and receipt of those funds are obscured from the policyholder (or in the latter case, often not applicable). The circumstances under which claims are covered are often ambiguous and fluid on a case-to-case basis, there is no transparency as to what the policyholder’s funds are being invested in, and the policyholder is completely removed from the distribution of profits, both in knowledge and, more crucially, in participation.
2. Interest-Bearing Investment of Funds
Unclaimed funds held by the conventional insurance carrier are invested in order to further generate profits for the business, often involving interest-bearing financial instruments such as government bonds. These interest-based returns on investment make their way back to the policyholder when the insurer pays for any claims that are successfully filed, rendering the interaction impermissible by Sharia law. Investing in vice companies (with respect to Sharia law, e.g. alcohol manufacturers, pornography sites, sports-betting platforms, etc.) is yet another layer of prohibited activity of conventional insurance that is circumvented in MGM.
3. Gambling with Premiums
A conventional insurance policy involves the policyholder through premium payments with only a chance that they will see that money in the form of filing a claim. An analogy between conventional insurance and blackjack can be made as follows: we can liken premiums to placing continuous bets into the pot, filing a major claim (upon the pure chance of a covered event occurring, e.g., a car accident) to “winning” the hand and receiving more than what was paid, and not filing a claim to the House winning this continuously growing pot. And if we may stretch out this analogy for one more crucial point: the House always wins.
How does the Mutual Guarantee Model work?
At a very high level, MGM forms a group of policyholders wherein each member contributes a recurring payment to the group’s fund pool. This is analogous (but structurally not identical) to a monthly premium in conventional insurance. Through their contributions each member assumes a portion of the risk of all other members, as does the insurer. In the event that a claim is made, each policyholder commits a pro-rata contribution from the pool absorbing the brunt of the claiming policyholder’s financial coverage. So far, this sounds nearly identical to conventional insurance, doesn’t it, save a few semantic differences.
The key differences reveal themselves in the management of the fund pool. Because the insurer is not assuming the entire risk in MGM, the policyholders, who still bear some of the risk, now have the right to their share of profits in the event that their fund pool is in surplus at the end of the contract term. It’s their own money being pooled to cover their own risk, after all. This property of MGM goes both ways: in the case that the fund pool is in deficit, policyholders may have their premiums raised in the next contract term. Investors often intervene to supply funds via interest-free loans* in the event of an off-by-one deficit; however if the claim activity of a pool contributes to regular deficits, it is prudent, and frankly justified, for the insurer to require higher premiums in the next contract term.
*Yes, you read that right—interest-free loans. Interest-free, as in, only the principal is paid back. Interest is forbidden under Sharia law, but before you decry such a concept, it is actually quite rational for shareholders in the company to provide such loans. Under MGM, shareholders earn fees on pooled funds and thus have an incentive to aid in improving pool health. Covering a pool deficit allows the fund managers to adjust premiums to allow for surplus in the next contract term, benefiting the lender in the (not so) long run.
Stakeholders of the Mutual Guarantee Model
1. Policyholders
These are the purchasers of the mutual guarantee product. In exchange for monthly premiums outlined in an exhaustive contract with the insurer, the policyholder is fully relieved of the insured risk in question. They may submit a claim, and can reliably expect guaranteed coverage for any outcome that was agreed upon in the contract. No surprises, no takebacks, no ad hoc coverage adjustments. In the event that the fund pool is in surplus upon the contract term’s expiration, policyholders may reclaim their pro-rata contribution, as said profits weren’t claimed by the pool members.
2. Insurer
This is the actual insurance company whose responsibility it is to formally offer MGM as a financial product, collect and manage the policyholders’ funds, and investment these funds in order to generate returns to pay for operational costs. The insurer also generates revenue by collecting a percentage fee from the fund and by sharing in the profits in the event of a fund surplus.
3. Shareholders
The shareholders, as in any traditional company, provide upfront capital in exchange for owning shares in the company. This capital is used for operational expenses as well as for covering fund deficits in they event that they may occur. Shareholders receive dividends for their investment in the insurance company.
4. Sharia compliance board
This board consists of scholars of Islamic law who are tasked with ensuring that the insurer’s MGM implementation as well as the financial activity involved in its operation are compliant with Sharia law. Products offered to customers, contract adherence, and investment strategies are regularly placed under the scrutiny of this board. The presence of this board provides continued assurance for any Sharia-observing policyholders, employees, and investors.
Sources
Islamic Finance for Dummies by Faleel Jamaldeen, DBA
https://aims.education/study-online/takaful-meaning-definition-and-principles/