After reading this chapter, you should understand:
- The concept of insurance
- The history of insurance
- The functions of insurance
- The principles of insurance
Introduction
Takaful is an Islamic alternative to insurance. To better understand how takaful works, it is useful to first explore and understand insurance in terms of how and why it is not considered compliant to the Islamic legal and values system, called Shariah, and how takaful can be an effective alternative. Therefore, this chapter focuses on understanding the basic concept of insurance, its history, its functions and its fundamental principles. Real-life small case studies are provided to aid understanding.
As human beings, we are exposed to several types of risk. In principle, these risks represent deviations from our expectations, which may cause damage to us and our belongings that have value for us. Two such risks are the possibility of losing our life and the possibility of losing our valuable property. In response, people, over a long period of history, have developed techniques to mitigate, transfer and manage these risks, as discussed in Chap. 4. Insurance, if managed properly, can be an effective technique for mitigating and transferring of such physical risks. In a simplest form, an insurance company collects premiums from clients and pays those clients compensation if an insured event occurs. Insurance companies keep these premiums in a fund through which they invest to earn income.
Definition of Insurance
From a clients’ point of view, insurance is a mechanism in which a client transfers a financial risk to an entity that provides compensation if an insured event occurs. Different kinds of insurance cover exist to meet clients’ different needs; examples include life, health, fire, motor and marine insurance. For such an arrangement of risk cover, there are always at least two parties to an insurance agreement: the insurance company and the client. Cover commences when an agreement is affected between the client and the insurer. The client is also, popularly, called the insured or the policyholder, and such clients can be an individual, company, government or any identifiable entities, such as civil society organisations.
Let us explain the mechanism of a simple insurance with the help of the following two case studies.
Case Study 1.1 Life Insurance
Adam contacts an insurance company to take out a life insurance policy for USD 100,000. If the company agrees to provide this cover, it must pay Adam’s nominee a sum of USD 100,000, on the condition if Adam dies. In return, Adam must pay for the cover, USD 5000 a year. Adam agrees and makes his first payment to the insurance company, and the company agrees to provide the cover. Adam is now considered insured by the insurance company.
USD 100,000 is the sum assured, and USD 5000 is the premium. The company will pay a death claim of USD 100,000 to the legal heir if Adam dies, while Adam must pay the company USD 5000 every year. Usually a client will provide the name of their legal heir when they arrange their life insurance. The named legal heir is also called the beneficiary or nominee of the policy. The beneficiary can be the widow, widower, child or/and parent of the client.
Sum assured: USD 100,000
Premium: USD 5000
Case Study 1.2 Car Insurance
Bilal runs a travel company and decides to insure its new fleet of 5 cars worth USD 500,000 and pays a premium of USD 15,000 to the insurance company for a year. Here, USD 500,000 is the sum assured, and USD 15,000 is the premium. The insurance company will cover any costs associated with agreed types of losses the cars experience during the covered period.
Premium: USD 15,000
Sum assured: USD 500,000
A Brief History of Insurance
The development of insurance, as phenomenon, is the result of various problems that humans faced in history, which provide a rationale for why we have such diversified forms of insurance today. In the following, we discuss a brief history of the most common types of insurance policies.
Marine Insurance
Goods have been traded through sea routes for centuries. However, in the past, ships encountered many dangers while at sea and were often destroyed, leaving the merchants destitute and who sometimes die. Chinese merchants, for case study, used to insure the goods that they were transporting through ships to various parts of the world.1 Upon realisation of defined losses during the voyage, the peer merchants used to join hands and contribute to assist those who had suffered the loss.2
In the seventeenth century, it became more common to insure ships and cargoes. For case study, in England, such merchants would meet at coffee houses to agree on insurance contracts. One such coffee house, situated near the River Thames, was owned by Edward Lloyd.3 Around the year 1688, Edward Lloyd started to encourage merchants to come to his coffee house to carry out their business, because this would bring more business to his coffee house. The merchants attracted insurance experts, who also began frequenting the coffee house in order to get business from the merchants. At that time, the insurance experts would write down the details of the ship and cargo on a piece of paper and sign under a horizontal line.4 Signing under that line led to the terms underwriter and underwriting being coined, which are still used in insurance. Today, the underwriter is the expert who decides to accept or reject a client’s request for insurance, the sum assured and the premium.
Today, marine insurance covers all forms of transport: sea, air, rail and road. However, because of its history it is usually called ‘marine insurance’.
Fire Insurance
Fire insurance is claimed to have begun after the Great Fire of London in 1666. In that fire, approximately 13,200 homes, 87 churches and dozens of public buildings were destroyed.5 This unfortunate event compelled people to make arrangements for financial compensation when such incidents happened. Insurance companies started establishing themselves during the same period. This marked the beginning of fire insurance. As time passed, one by one, other dangers began to supplement basic fire insurance. These include earthquake, riots and strikes, atmospheric disturbance (flooding, heavy rain, etc.), explosions, aircraft damage and impact damage.
Motor Insurance
Motor insurance was introduced a little later than marine and fire insurance. The first mechanically propelled vehicle appeared on British roads in 1894. At that time the roads were not busy, but there was still a chance of having an accident. Therefore, by 1898, insurance companies had started providing cover to compensate people for losses resulting from accidents involving vehicles.6 Today, insurance companies mostly provide cover for accidental loss (partial, total and third party) and theft.
Life Insurance
History also shows us that life insurance originated in Italy,7 where people started to form burial societies, which would collect premiums from participants and pay the burial expenses out of the premiums collected. These societies established pool funds to manage their expenses. Each participant was required to pay an equal amount into the fund. According to Peggy Mace:
The oldest life insurance policy for which there is surviving evidence was taken out for William Gybbon on 18 June 1583, in London. Gybbon was a salter of fish and meat for the city of London. He bought a one-year policy from Alderman Richard Martin and passed away before the end of the year. At first the company refused to pay, but after some legal wrangling, Martin won the case.8
Functions of Insurance
A contemporary insurance usually performs the following three main functions, as exhibited in Case Study 1.1:
- Providing a risk-transfer mechanism.
- Creating a common pool.
- Setting equitable premiums.
Providing a Risk-Transfer Mechanism
The primary function of insurance is to transfer risk from insured to insurance company, against a premium.
Let us explain the risk-transfer mechanism with the help of Case Study 1.3.
Case Study 1.3 Transferring Risk
Caroline owns a car worth USD 60,000. The car is one of Claire’s most valuable possessions. If it is stolen or damaged, Caroline understands that it will cost her a handsome amount of her hard-earned money.
To manage these and other risks associated to her car, Caroline contacts an insurance company to explain these concerns and asks to arrange insurance for the car. The insurance company tells Caroline that they are willing to accept the risk in exchange for a premium of USD 18,000. If Caroline pays the premium, the car will be insured against the risk of theft and accidental damage for 12 months, starting with the date of insurance contract signed by parties.
Caroline agrees and pays the premium to the insurance company; the agreement is put in place and the insurance company issues an insurance policy containing all the details of the contract. The insurance policy will not stop the car being stolen or damaged, but if either of these losses occurred, the insurance company will pay Caroline financial compensation to cover the costs involved.
Therefore, we can say that Caroline has transferred the risk of financial loss to the insurer company in exchange for paying a premium.
Creating a Common Pool
As explained earlier in this chapter, merchants once had to transport their goods by ship. Navigational skills were not as good as they are today, so the merchants were exposed to many dangers.9 It was quite common for goods to be destroyed, and the merchants had to bear huge financial losses when this happened. To manage this risk, fellow merchants would contribute money to compensate merchants when they suffered a loss.
This arrangement certainly removed the risk of total loss from any one merchant, as each of them knew that their loss would be compensated. However, the problem with this arrangement was that it was not certain that the mutual contribution from the merchants would provide full compensation for the loss. Moreover, because the merchants agreed to share any losses that occurred, they knew how much they had to contribute only after the loss took place. If there was no loss, they would have nothing to pay, but if there were losses, then the exact amount could only be determined after the event.
This raises the question: can we know what the loss will amount to in advance? The answer is yes—we can estimate an expected amount of loss if we create a common pool to which a large number of clients contribute. For case study, if a company wants to provide fire insurance for 10,000 homes, it can look at statistics that show how many homes are damaged by fire in one year. The company can then extrapolate that information to predict how many of the 10,000 homes it wishes to insure will be damaged by fire. It is difficult to predict whether or not a particular house will be damaged by fire, but we can comfortably assess how many homes will be damaged by fire, with some good estimates.
The size of the pool is important here. Let us suppose a homeowner approaches an insurance company to arrange fire insurance. The company tells the homeowner that it is not providing fire insurance at the moment, be...