Conventional insurance is a contract whereby the insurance company, for a price called the premium, promises to financially compensate the insured (the policy holder) should certain adverse events occur (e.g. a house fire, theft, car accident, etc.)
Non-interest insurance (takaful) literally means joint guarantee and is based on the principle of mutual help. It is similar to the concept of co-operative insurance.
Key Principles of Takaful
Mutuality - the basic objective of takaful is to pay a defined loss from a defined contribution.
Ownership of Takaful Fund - policy holders are the owners of the takaful fund and therefore entitled to its profits. The surplus or profit distribution depends on the model of operation adopted.
Elimination of Uncertainty - the Takaful premium is treated as a donation rather than a payment for a service which could possibly not occur. By using the concept of donation policy holders voluntarily relinquish their rights on the amount contributed to the common fund. The fund is used to cover any member that suffers a loss.
Management of Takaful Fund - the fund is managed by a Takaful Operator typically using a Mudarabah contract or a Wakala contract or a hybrid of both.
Investment Condition - investments are prohibited in non-ethical industries, e.g., casinos & pornography and require the use of non-interest based instruments.
Differences Between Conventional and Takaful Insurance
Takaful is different to conventional insurance in two ways. Firstly, in a takaful structure policy holders contribute to the common fund which is intended to jointly guarantee each other against losses. If at the end of the period there is a surplus left in the common fund this can be shared between the Takaful Operator and the policy holders depending on the model used.
Secondly, insurance companies will invest premiums from policy holders to make additional profit. Takaful companies can only invest the premiums in a manner compliant with ethical non- interest finance principles as described earlier.