Shariah-compliant response to conventional insurance: How Takaful offers a solution

Islamic finance is built on a foundation that contrasts sharply with conventional financial systems.

Unlike the global financial system, which is deeply rooted in interest-based principles that often lead to inflationary pressures, Islamic finance is driven by the principles of wealth preservation and equitable growth through investments that share both risk and reward. By rejecting riba (interest), Islamic finance presents an alternative that could address the pressing social justice issues of our time, particularly the widening financial inequality.

At the heart of Islamic finance is a set of prohibitions, derived from Shariah law, that dictate what is impermissible.

These include the prohibition of Riba (interest), Gharar (uncertainty), and Maisir (gambling).These principles not only guide Islamic banking but also extend to Islamic insurance, or Takaful.

Understanding the Prohibitions

1. Riba (interest):
Riba, or interest, is the most well-known prohibition in Islamic finance. It refers to any guaranteed interest on loaned money, regardless of the form it takes - whether monetary or otherwise.

Conventional insurance companies typically invest customer premiums in interest-bearing financial instruments, thus violating the prohibition against riba.

Moreover, the very structure of conventional insurance can be seen as involving riba, while scholars highlight the insurance contract itself as including riba since a small sum of money (premiums) is exchanged for a large sum of money (claims payment). The excess amount of the claim payment over the premium is considered a form of riba. 

2. Gharar (uncertainty):
Gharar refers to excessive uncertainty in commercial contracts, where the outcomes are ambiguous or unclear. 

Conventional insurance often involves a significant degree of gharar because the benefits to the insured are not always well-defined. For example, in auto insurance, the payout depends on various factors, such as the extent of damage and the insurance company’s assessment, leading to uncertainty about what the insured will receive.

3. Maisir (gambling):
Conventional insurance can also be viewed as a form of gambling.

In a typical insurance contract, the insured pays premiums with the hope that they will receive a payout in the event of a claim. If no claim is made, the insurance company keeps the premiums, and the insured receives nothing.

This creates a zero-sum situation where either the insured or the insurer benefits at the other's expense, aligning the contract with the principles of gambling, which is strictly prohibited in Islam.

Why conventional insurance is not Shariah-compliant

Given these prohibitions, it is clear why conventional insurance is considered haram (forbidden) in Islam. The practice of conventional insurance violates the core principles of Islamic finance, leading many Muslims to believe that all forms of insurance are impermissible. However, this is a misconception.

Prophet Muhammad (PBUH) himself endorsed the concept of preparedness against known risks. This approach was further exemplified by the practice of Aqilah, where members of a tribe would contribute to a communal fund to support each other in times of need.

Thus, the prohibition is not against the concept of insurance per se, but rather against the way it is practiced in conventional systems, which incorporate elements of riba, gharar, and maisir.

The emergence of Takaful

In response to the challenges posed by conventional insurance, Islamic scholars have developed Takaful, a cooperative form of insurance that aligns with Shariah principles.

Takaful is rooted in the idea of mutual assistance, where participants contribute to a common pool to support each other in times of need. This model eliminates the issues of riba, gharar, and maisir by ensuring that the interests of all participants are aligned, and any surplus is redistributed among the members.

The potential for Takaful is enormous, not just within the Muslim world but globally, as it offers an ethical alternative to conventional insurance.

With the advent of blockchain technology, cryptocurrencies, and decentralized autonomous organizations (DAOs), there is now an unprecedented opportunity to create a truly transparent and cooperative insurance system based on Takaful principles. For example, blockchain technology presents a vital opportunity to advance Takaful by enhancing transparency and security, aligning perfectly with Shariah principles.

Its decentralized ledger reduces fraud through real-time, verifiable claim management and automation, cutting down on manual processes and administrative costs while improving efficiency (Khir & Said, 2020; Ibrahim et al., 2022).

Sharene Lee is the chief operating officer at Takadao