With over one billion Muslims globally, there are few that would doubt the potential demand for Shari'ah compliant insurance, say David Whear and Annabel Western

"The first step in the evolution of ethics is a sense of solidarity with other human beings" said Albert Schweitzer the 1952 Nobel Peace Prize winner. Schweitzer has, in many ways, neatly summarised the Muslim need for takaful companies. That need exists because Muslims worldwide must comply with Shari'ah (Islamic law) in all aspects of life, including financial transactions.

Takaful, the expression now given to Islamic insurance, literally means "solidarity". The principles of co-operation - and other ethical considerations - are at the philosophical and legal heart of takaful. The objective of Shari'ah is the preservation of the human and the continuation of its goodness individually and collectively. The need to do what is morally or ethically "good" underpins much of the thinking behind Shari'ah.

With well over one billion Muslims in the world (1.6 million in the UK) accounting for approximately 22% of the world's population, the potential demand for Shari'ah compliant insurance products is enormous. Since 1979, when the first takaful company was established, 250 further takaful and re-takaful insurers have entered the market. Premium growth is expected to be in the range of 20% to 25% per annum.

But why is conventional insurance unlawful for Muslims? Shari'ah scholars have identified two principle problems. First, contracts that contain a significant element of Gharar - which arises where the object contracted for is not real or may never come about - are void and therefore Haram (prohibited) under Shari'ah law. Under conventional insurance contracts it is argued the insured pays a premium but may never receive any real benefit in exchange for that premium. Whilst there has been debate amongst Shari'ah scholars as to whether the security offered by insurance is a real benefit, the influential and respected Islamic Fiqh Academy (part of the Organisation of Islamic Conference) resolved in December 1985 that conventional insurance contained a major element of Gharar and was therefore unlawful for Muslims unless there was no alternative.

That resolution stated that co-operative insurance, based on Tabarru' (a donation) given upon the condition of self-benefit would be acceptable.

So, in takaful structures, participants (the policyholders) donate to a central takaful fund - in conventional terms, pay a premium - and as a condition to that donation they require the provision of insurance cover.

Whilst the distinction between this form of donation-based contract and conventional insurance may appear to be a matter of semantics, it is an important one and the ruling of the Fiqh Academy is still in force today.

The second problem is that Riba (interest) is not permitted in Shari'ah compliant contracts. Takaful companies may, therefore, only invest in equities or other non-interest generating investments, and not in bonds or bank deposits. Further, investments may only be made in ethically sound companies - that is a company whose main line of business is a permissible activity under Shari'ah. It would not, for example, be permissible to invest in a brewer, because alcohol is not permissible, or in a bank, because banks earn a significant amount of revenue from interest; similarly companies that are heavily geared and therefore pay significant amounts of interest. These ethical considerations would seem to limit significantly the investment opportunities for takaful companies. However, some relief is provided by the "auxiliary" principle: that is, where something that would otherwise be impermissible is auxiliary to something that is permissible, then that impermissible thing may be permissible. So, where an entity earns revenues that are not permissible, but only in a way that is auxiliary to its main activity and to an extent that in Shari'ah terms is "tolerable", the takaful company may invest in that entity. There is a Dow Jones Islamic Market Index that tracks companies that meet the generally accepted criteria for permissible investments.


So, how do existing insurers or investors establish and profit from takaful companies? There are three main structures: Wakalah, Mudarabah and Waqf.

Before explaining those structures in a little more detail, it must be remembered that, whilst in a number of Muslim countries the regulatory authorities and governments have facilitated regimes which expressly accommodate takaful, local regulatory requirements in other countries - particularly in relation to capital adequacy and investment policy - will obviously need careful consideration when structuring takaful companies.

Under each of the takaful structures, the founding shareholders contribute initial capital to the operating company, which manages the insurance operation, in the usual fashion to cover start-up costs and the remainder is invested. The founders appoint a Shari'ah advisory board which advises and confirms that the structure and the investment of the funds are Shari'ah compliant. The composition and standing of the Shari'ah advisory board is important, not least because it can materially influence customers' choice between different providers. The founders are not bound to follow the advice of the Shari'ah advisory board, but if they do not there is a risk that the advisers may publicly announce that the company is not compliant. Donations (premiums) from the participants are paid into the takaful fund, which is available for capital adequacy requirements, reserves, claims and claims expenses, but not for general overheads and operating expenses, which are paid by the operating company.

Under the "Wakalah" model, the operating company is regarded as an agent and is therefore entitled to fees for its services. Fees may be deducted by the operating company from the contributions made by the participants to the central takaful fund and from any profits derived from investing the takaful fund. The agent may not share in any surplus in the takaful fund - that fund is owned by all of the participants and theoretically may be distributed, although in reality it is simply held as reserves.

The second structure is the "Mudarabah" model. Here, the operating company established by the founder is in partnership with the participants and is entitled to a fixed percentage of any profits that are derived from investing the takaful fund. To be Shari'ah compliant, there must be no guaranteed level of income. As with the Wakalah model, the operating company may not share in any surplus in the fund, which is owned by the participants.

"Waqf" means public endowment. Participants donate to a central fund which has no owner; it is "as if it were owned by God". As with Wakalah and Mudarabah, the fund supports claims payments and direct expenses.

The operating company derives its income from either a fee from or a share of any profits made from investing the fund. Participants' donations are permanent and, in contrast to the theoretical position of the other two structures, any surplus may not be distributed to them.

The theory then is that the operating company may not share in any surplus generated by the relevant takaful fund. There is, however, some debate amongst Shari'ah scholars on this subject and a number of takaful operators have taken fees from the surplus. The debate centres around the "auxiliary" principle explained above. It is argued by some that it is permissible for the operator to take a very small share of any surplus, as this would be auxiliary. Most scholars reject this argument. The auxiliary principle is extended in some instances to allow, for example, in the Wakalah model the agent to take a small share of the investment profit.

The Wakalah and Mudarabah models are very similar to conventional mutual insurers. Leaving aside the arguably semantic distinction between the donation-based contract and a premium-based contract, the only real difference is that mutuals may invest in interest-generating assets. Takaful is not such a difficult concept for conventional insurers to adopt.

The statistics mentioned at the beginning of this article would suggest that there is vast potential for insurers, particularly when one considers the relatively low levels of insurance penetration in Muslim states, coupled with the likely increase in demand for insurance. Saudi, for example, has within the last year introduced three compulsory covers and new takaful laws. Further, there are several millions of Muslims buying conventional insurance covers in Western countries.

Perhaps, though, it is re-takaful (that is Shari'ah compliant reinsurance) that may prove to be the exciting investment opportunity. Arguably the takaful market will only be able to develop, expand its offering and respond to the anticipated increased demand for Shari'ah compliant products if there is a reinsurance market to share the catastrophic exposures and provide the capacity for growth. The structure of the Lloyd's market - and the first takaful syndicate was established last year by Creechurch Underwriting and the Salama Islamic Arab Insurance Company - is conducive to a re-takaful operation: a potentially small number of participants (reinsureds) coming together and sharing risk through a syndicate managed by an operating company (managing agent) on a fee or profit commission-based arrangement.

Lloyd's has long had a reputation for innovation and it would not be surprising to see the market respond to the takaful demand for reinsurance capacity.

- David Whear is a partner in the Corporate and Regulatory Insurance Team at Norton Rose and Annabel Western is an associate in that team.