Differences between Conventional and Takaful Insurance - Essay Example

Analyze Differences between Conventional and Takaful Insurance Name Institution Course Date Analyze Differences between Conventional and Takaful Insurance Introduction Insurance has become a great financial instrument in the developed world. Although insurance uptake in developing countries still remain low, the majority in advanced economies understand the importance of having an insurance cover for life and property as it provides people with a peace of mind by shifting risk to third parties (Swartz & Coetzer, 2010). The term insurance, conventionally refers to a contract between two parties, the insurance company and the insured, in which the insurance company undertakes to indemnify the insured against the losses or damages for the property insured against under the terms and condition with the insured paying a small certain amount called premium. This way, insurance provides the insured with a peace of mind my transferring risk exposure to the insurance company (Mahmood, 1991). Despite the value of insurance, it is noted that a significant number of Americans still opt not to have insurance cover and only insure against their cars that the law requires that they must be insured against in order to ply the roads. However, even as most people are conversant with how conventional insurance works, a new form of insurance called Takaful is increasingly becoming popular in the world due to globalization. Takaful is regarded as the “Islamic equivalent of insurance” (Swartz & Coetzer, 2010). Even as Takaful becomes popular, the majority of people still do not understand the differences between takaful and conventional insurance. The objective of this paper is to describe the differences between takaful and conventional insurance companies in terms of principles, terminologies, mechanisms and financial statements. Differences between Takaful and Conventional Insurance Takaful are increasingly becoming popular form of insurance in the modern day society. Although takaful insurance is relatively young, the concept having been introduced for the first time in 1979 following the establishment of the first takaful insurance provider (Wahab et al., 2007), the Islamic Insurance Company of Sudan, the number of takaful has since grown over the years and currently numbers about 130 and has since spread globally (Swartz & Coetzer, 2010). However, the majority of takaful are still concentrated in Islamic states, especially GCC countries, such as Kuwait, Oman, Bahrain, UAE, Saudi Arabia and Qatar. The growth of takaful in these parts of the world is much ahead of conventional insurance market. The market for takaful is expected to be worth about $4 billion over the new few years up from the current market value of $170 million (Swartz & Coetzer, 2010). Globally, it is estimated that takaful industry growth rate stands at about 20% per annum compared to conventional insurance market whose growth rate stands at 2.5% per annum (Aris, 2004). This clearly indicates that takaful is becoming a big industry and is spreading very fast to different parts of the world. The first major distinction between takaful and conventional insurance is found in terminologies. Takaful has certain terminologies that are unique to takaful insurance companies and these are commonly referred to as takaful models or elements. In conventional insurance, the policyholder is expected to pay a given small amount of premium during the insurance period and this premium is lost if no loss or damage occurs to the claim insured against (Swartz & Coetzer, 2010). At the same time, the policyholder stands a chance to gain more than the premium paid to the insurance company in the event that the claim insured against occurs in which the insurance company has to indemnify the insured for the loss suffered. Because this is a form of gambling, it is not allowed under Shariah law, which means that no takaful business can engage in any form of gambling. Instead, in takaful insurance, the policyholder is considered to have donated a sum of money to assist each of the policyholders in case any one of them suffers damages (Mahmood, 1991). In this regard, in takaful, the parties contribute money and mutually agree to use the money contributed and any other profits generated to help each other in the event that one of the members suffers some loss. Therefore, the principle of indemnity does not apply in takaful insurance companies. The other term or element that distinguishes between the two is Gharar. Gharar is a term used in takaful to mean uncertainty (Swartz & Coetzer, 2010). Under Sharia law, any contract that involves uncertainty, probability or doubt is prohibited (Aris, 2004). This implies that no Islamic business is allowed to engage in a contract that involves uncertainty or probability. On the other hand, conventional insurance contracts are purely involves uncertainty. In such contracts, neither of the parties, the insurance company nor the insured knows when the damage or loss insured against will occur, the extent of the loss and the amount of loss that might occur. This implies that parties in a conventional insurance contract do not know what might happen to the loss being insured against, meaning that contract is based on probability that involves uncertainty. However, such contracts that involves uncertainty is prohibited under Sharia rule and as such, takaful insurance businesses does not operate on such principle (Ali, 2006). Instead, in takaful, the policyholders contribute a fund which is structured in such a way that the policyholders use the money to help each other in the event that one of them suffers losses. Unlike in conventional insurance, where the insurance company guarantees to pay uncertain amount in the form of indemnity, there is no such guarantee from takaful insurance company to a policyholder (Mahmood, 1991). It is important to note that, in takaful insurance, the policyholders are kind of grouped in a mutual assistance contract and that there is no uncertainty or probability factor at play as the policyholders in takaful contracts pool funds and also have the chance to generate surplus income from the amount contributed as any profit generated from the contract is shared among the policyholders. The two also differs in the sense that, whereas conventional insurance involves risk transfer as its main principle that is aimed to cushion the insured against uncertainty, takaful insurance involve risk sharing (Swartz & Coetzer, 2010). In this kind of insurance, the risk suffered by one of the policyholders is shared among all the policyholders. The risk insured against is still retained by the policyholder and does not transfer it to the insurance company, which is different with how conventional insurance operates in which the insured transfers all the risk insured against to the insurance company. The other term that applies to takaful that differentiates it from conventional insurance is Riba. Riba is a term that denotes interest, which involves making returns on money. Any activity that involves interest is prohibited under Sharia rules. Conventional insurance companies are free to invest in interest-bearing assets, such as government and corporate bonds. On the other hand, takaful are restricted to an interest-free system (Mahmood, 1991). This implies that takaful insurance companies must ensure that funds contributed by policyholders and shareholders are not invested in assets that charge interest or Riba. At the same time, takaful insurance companies are prohibited from dealing with banks that practice Riba (Wahab et al., 2007). For example, this implies that takaful entities cannot borrow money or transact any business with a bank, such as JB Morgan that is involved in Riba. Takaful and conventional insurance are also distinct with regards to their approach to investments. Investment is an important part of doing business because it helps ensure that a company is financially sound. However, in takaful, there are restrictions placed on the assets that takaful entities can invest in by Sharia rule. The basic principle of investment under Islam is that any reward must involve risk (Mahmood, 1991). As such, takaful businesses are only allowed to invest in stocks that are approved by Sharia rule. For instance, takaful firms cannot invest in debt-based assets, such as bonds as doing so would amount to a violation of the principle of riba. They can also not invest in assets with guaranteed or minimum returns since this amount to a violation of the risk/reward sharing principle. Additionally, takaful firms cannot invest in businesses, such as casinos and gambling businesses as this would violate the haram practices (Wahab et al., 2007). Comparison of financial Statements of Takaful and Conventional Insurance Companies The differences between the two financial statements can be compared using ration analysis. The two insurance companies whose financial statements are used to compare the financial statements of takaful and conventional insurance are Salama-Islamic Arab Insurance and National General Insurance Co., which are based in the United Arab Emirates and provide insurance products to the population (Salama-Islamic Arab Insurance., 2015; National General Insurance Co., 2015). National General Insurance Financial Statement Analysis Liquidity ratio = Current Assts/Current liabilities 856,569,213/683,961,941 = 1.3 Net Margin = Net Profit/Sales 23,503,714/ 308,356,344 =0.1 Salama-Islamic Arab Insurance Financial Statement Analysis Liquidity ratio = 3,079,682/2,352,985 =1.3 Net Margin = 36,744/ 730,805 =0.1 Company Current ratio (2014) Net Margin (2014) National General Insurance Co(Conventional) 1.3 1.3 Salama-Islamic Arab Insurance (Takaful) 0.1 0.1 It is surprising to note from the ratio analysis that conventional and takaful insurance companies are the similar in terms of liquidity and profitability. The current ratio above indicates that both Salama-Islamic Arab Insurance and national General Insurance had equal current ratio above one, which implies that they are both liquid and have enough current assets to be able to service their obligations as and when they fall due. In other words, none is more liquid than the other. Regarding profitability, it also emerges from the financial statement analysis that the two companies had profit margins of 10%. This implies that neither conventional nor takaful insurance is profitable than the other. Conclusion Takaful is a fast growing form of insurance globally. As indicated in the report, the first takaful insurance company was established in 1979 but has grown and currently number over 130 spread in different regions in the world. Takaful are just the Islamic alternatives to conventional insurance. Although the aim of takaful and conventional insurance is to provide insurance cover to policyholders, the discussion has indicated that the two differ in many different ways, including principle, terminologies, mechanism and financial statement. The main difference, however, is that, whereas conventional insurance operates on the principle of indemnity, takaful operates on the principle of mutual help and cooperation/solidarity. References Ali, K. M. M. (2006). Basis and models of Takaful: The need for Ijtihad. ICMIF series of Takaful, 3, 1-5 Aris, Y. B. W. (2004). Takaful-An option to conventional insurance: A Malaysian model. Working Paper, Faculty of Business and Management, Universiti Teknology MARA, Malaysia, 1-2. Mahmood, N. R. (1991). Takaful: The Islamic system of mutual insurance: The Malaysian Experience. Arab Law Quarterly 6(3), 280-296. National General Insurance Co. (2015). Financial statements 31 December 2015. Retrieved from http://www.ngi.ae/wp-content/uploads/2016/03/Full-Financials-31-December-2015.pdf Salama-Islamic Arab Insurance. (2015). Islamic Arab Insurance Co. (Salama) and its subsidiaries. Retrieved from http://salama.ae/salamalife/uploadfiles/SALAMAFS_31122014.pdf Swartz and Coetzer (2010).Takaful: An Islamic insurance instrument. Journal of Development and Agricultural Economics 2(10), 333-339. Wahab, A.R.A, Lewis, M.K. and Hassan, M. K. (2007). Islamic Takaful: Business models, Shariah concerns and proposed solutions. Thunderbird International Business Review 49(3), 371-396. Read More