How Islamic Insurance Works

The discussion below is in two parts. First part briefly discusses the Islamic concept of insurance and the second briefly highlights why commercial insurance is forbidden in Islam. There is also a good discussion of Islamic Insurance here.

Part 1 – Islamic Concept of Insurance

Source: Economic Doctrines of Islam by Afzal-ur-Rahman, p. 147-149

The basis of insurance in its original form seems to be the spirit of self-help and mutual security against a common danger. People organised such institution or groups to protect the interests of their members from any danger or loss. It signifies a feeling of self-help and mutuality among the members. All the members co-operate in safe-guarding the interests of its individual members. If any individual member is faced with a calamity beyond his means, all the members contribute to meet his loss. It is organised from within and not from outside as in case of commercial insurance.

It is formed to cover its members for specific risks which arise out of some trade or profession. There is no profit motive at all. The policy-holders are themselves the organisers, controllers and managers of the entire business of the association. They distribute the loss of a member inflicted with any calamity among all the members and make no profit. It is thus organised by the members, who are also the policy-holders, on a non-profit basis.

A mutual insurance society may be defined as an unrestricted union formed by the insured themselves who undertake to pay, on an agreed scale, periodical contributions for the purpose of covering losses sustained by some of them in the cases of stipulated future contingencies, such losses being pre-rated periodically among all members.

The term mutuality is used in two senses, “first, as a method of distribution of income, and second, as a method of joint guarantee. In the first sense, it deals with the distribution of income over a given period of time. Pure mutuality affects such a transfer of income between the members in each year.” Pigou says, “that the deviation of collective consumption in each year from average collective consumption is spread evenly among them. By saving collectively instead of individually, a group of people can greatly lessen the amount of saving that is required, in order to reduce the variability of the representative man’s consumption in any given degree.”

In the second sense it is used as a method of joint guarantee against loss of any of its members. “The members of a group guarantee jointly that if any of them suffers a disaster, he will receive a certain sum of money to help him to meet the loss.” The mutuality theory has taken stock of the fact that in its early stage insurance was organised to a great extent on a mutual and semi-mutual basis. This theory emphasises the social value of insurance and defines it “as a brotherhood of men who unite against the all-destroying effects of the unfettered forces of nature.”

The few writers of the Utilitarian School, who devoted some attention to insurance, came very near the definition of the mutuality theory. They thought that the great advantage of insurance lay in the fact that “when applied in its natural and most common way, it considerably alleviates the misery of mankind”. The gratification of human needs and wants can, to a great extent, be fostered by insurance, which they describe as “a kind of hedging against extreme misfortune by an agreement between a certain numbers of persons, namely those who take policies in the same office, that those who are fortunate shall support those who are unfortunate.”

Commercial insurance as practiced in modern times is totally different from normal or co-operative insurance in many respects. Firstly, it is organised by members of an outside party who are not themselves the policy-holders. Secondly, it is not controlled by the insured, thirdly, there is no conscious or active participation by the insured, fourthly, the risk is transferred to an outside group of persons and is not shared by the insured, fifthly, there is no self-help or humanitarian nature in it, sixthly there is no element of mutuality and co-operation in this form of insurance; and seventhly, there is “nothing of a collective nature because the combination and offsetting of risks by the underwriters concerns only the insurer and not the insured”.

It seems, therefore, unreasonable to emphasise the existence of mutuality or conscious participation in commercial insurance. It is different form of insurance and does not possess the basic elements of co-operative or mutual insurance. “How can all forms of insurance be mutual when this mutual character is actually unknown to the insurer and insured? What is the value of an economic interdependence between all the insured, and between the insured and the insurer, of which neither of them is aware? Such unconscious mutuality is of no use or value because it finds no manifestation in economic action. Only where it becomes a conscious expression of organised co-operative or mutual effort, only when it is expressed in a new form of social organisation, only then can mutuality become a real force in insurance and in other spheres of human economic activities.”

Part 2 – Why Commercial Insurance is Forbidden in Islam

Source: Economic Doctrines of Islam by Afzal-ur-Rahman, p. 140-141

Modern commercial/conventional insurance is prohibited because it consists of four unlawful elements:

Interest (Riba)

Riba is present in the commercial insurance business in all stages of its business, from the calculation of the premium to the compensation to the sufferer of a calamity. The entire funds of the insurance company are invested in fixed-earning (i.e., interest) investments and all the benefits paid to the insurees who have suffered a peril contain an element of riba. There is no denying the act that most, if not all, of the earnings, of the insurance company come from interest. On average, insurance companies invest over two-thirds of their funds in fixed-interest stock and about 11 percent in property, most of which bring interest.

Gambling (Qimar)

The entire basis of the insurance contract is on the happening of an uncertain event which may happen or may not happen at all. It is exactly like betting or lottery. The nature of premium money in commercial insurance is exactly like the stake money in gambling or betting. Likewise, the amount of compensation is as illusive as premium money. In spite of great progress in the science of statistics and the theory of numbers, the element of probability (i.e. gambling) cannot be eliminated from commercial insurance. Calculations in gambling are based almost on the same principle as in commercial insurance in order to ensure profits for the house (or bank). And insurance company, like the house in gambling, is rarely the loser.

Furthermore, insurable interest has and will always remain an enigma, especially in life insurance or the insurers as well as for the insurees. The nature of insurable interest will always present problems of the same kind as gambling or wagering.

Many eminent economists do agree with the view that commercial insurance is a form of gambling. And gambling is clearly prohibited in the text of the Qur’an and Sunnah of the Holy Prophet, and all Muslim jurists are also in full agreement about this.

Uncertainty (Gharar)

The element of Garar (risk probability leading to uncertainty of the final outcome of the insurance contract) is very dominant in commercial insurance. This risk probability is present in the total business of commercial insurance involving premiums, indemnity and the insurable interest. The element of doubt and uncertainty will always over shadow these variables because their fate is finally dependent on events which may or may not happen. If the event happens, the nature and extent of the damage has to be estimated.

Thus, both the parties in the contract are totally in the dark with regard to their obligation and liabilities to each other owing to the uncertain nature of the risk. The presence of an element of Garar therefore is evident in insurance business.

Ignorance (Juhala)

The insurance contract also contains an element of Juhala. As explained under Garar, the element of uncertainty is also very predominant in the commercial insurance business. As the basis of the insurance contract is the probable peril which cannot be predicted an element of uncertainly is unavoidable. No amount of progress and development in the science of statistics or theory of probability can assure us that the nature and extent of the peril is determinable before the happening of the event.

Again, an element of unspecified quantity both in respect to premiums and compensation is present in the insurance contract. The nature of insurance business is such that the element of uncertainty is indispensable and cannot be avoided under any circumstances. Thus it can be said that all the four unlawful elements prohibited by the Qur’an and Sunnah of the Holy Prophet i.e. riba, qimar or maiser, garar and juhala are present in the insurance contract.

In addition, elements of exploitation and unfair dealings are also present in the commercial insurance business. As has been explained earlier, there is plenty of evidence that suggests considerable exploitation and unfair play in the business of commercial insurance.