Chapter 4: Permissible Insurance Alternatives

When thinking about reducing certain types of risk (one can never "eliminate" a risk in the sense of full "insurance"), one often thinks of "buying insurance". The typical financial insurance contract used in North America and elsewhere would entail signing a policy with an insurance company whereby the insured makes periodic premium payments, and the insurance company promises to compensate the insured for damages or part thereof according to a well specified formula. The majority of Islamic ,jurists have concluded that this contract is invalid based on the prohibition of Gharar. Moreover, since many insurance contracts also include an investment component (e.g. certain types of term and life insurance), the insurance companies' investments in interest bearing bonds render such contracts invalid based on the prohibition of Riba.

The first thing to notice is that "buying insurance" is not the only method of risk reduction. We have already seen in the previous chapter how simple diversification schemes can reduce risks. As a matter of fact, the endorsed Islamic alternative to conventional insurance is the notion of cooperative or mutual insurance, [Note: Jurists often use the Arabic term "takaful', which means cooperative mutual insurance, for this contract. However, since variations on this term have recently been "trademarked" in Europe and the U.S., I shall refrain from using it lest the reader assume that I am endorsing any particular institution to the exclusion of others.] which is based precisely on the same logic of diversification used in that chapter.

Prohibition of financial insurance

Let us abstract from the prohibition based on Rliba for a second, and consider only the argument for prohibiting financial insurance based on the prohibition of Gharar. This prohibition, unlike the prohibition of Riba, is relative. AlBaji Al 'Andalusi (n.d., vol.5, hashiyah, under bay'u al Gharar) states:

His (pbuh) prohibition of bay'u at Gharar renders such a. sale defective. The meaning of bay'u al Gharar, and Allah knows best, refers to sales in which Gharar was the major component (ghalaba `alayhi) until the sale is justifiably described as bay'zc al Gharar. This is the type of sale which is unanimously forbidden. On the other hand, minor (yasir) Gharar does not render a sales contract defective, since no contract can be entirely free of Gharar. Thus, the [legal] scholars differ in determining which contracts are defective due to differences in opinion regarding the extent of Gharar inherent in each: sic. whether it is substantial and invalidates the contract, or minor and retains the contract's validity.

Taqiyyudin Al Subki explicitly summarizes the opinions of earlier jurists thus (Al Nawawi (continuation by Al Subki) (1995, vol. 9)):

The scholars said that the criterion for invalidity of the contract based on Gharar, or its validity despite the existence of Gharar, is thus: if necessity dictates committing Gharar which cannot be avoided without incurring an excessive cost, or if the Gharar is trivial (haqir), the sale is rendered valid, otherwise it is rendered invalid .... Thus, the differences among scholars are based on this general principle, where some of them render a particular form of Gharar minor (yasir) and inconsequential, while others render the same form consequential, and Allah knows best.

'Ibn Taymiya (1998, vol. 4) makes the same point as follows:

In this regard, the corrupting factor in Gharar is the fact that it leads to (kawnuhu matiyyat) dispute, hatred, and devouring others' wealth wrongfully. However, it is known that this corrupting factor would be overruled if it is opposed by a greater benefit (al maslahah al rajihah).

Thus, Al Darir (1997, pp.44 51) lists four necessary conditions for Gharar to invalidate a contract:

  1. It must be major.
  2. The potentially affected contract must be a commutative financial contract (this includes sales, but excludes gifts and charitable contributions, including "sharing" arrangements).
  3. The Gharar must affect the principal components of the contract (e.g. the price and object of sale, language of the contract, etc.).
  4. That there is no need met by the contract containing Gharar which cannot be met otherwise.

Many contemporary jurists, e.g. Al Zuhayli (1997, vol.5, pp.3415 3431), have argued that commercial insurance satisfies all four conditions. This opinion dates back at least to 'Ibn `Abidin (n.d., vol.3, p.273 onwards), who issued a fatwa forbidding marine insurance. [Note: As we have seen, the origin of the term risk, re secure, suggests that the origins of the analysis of risk and insurance lie in this area.] The Gharar, it is argued, results from the fact that the premium (price) is paid, where what is being bought is not well defined. The proponents of this view say that the insured may pay one small premium and collect a large sum if he can make a legitimate claim, and he may pay many premia without ever collecting any sum of money. Notice that "security/insurance" itself is not a valid object of sale under Islamic jurisprudence. In commercial insurance, jurists argue:

  1. The Gharar is argued to be quite substantial, since the amount to be collected from the insurance company may vary between zero and a very large sure, depending on chance.
  2. The commercial insurance contract is a sale contract, which is a commutative financial contract.
  3. The Gharar affects the object of sale, and therefore it is integral to the contract.
  4. The cooperative insurance alternative can meet the needs that are met by commercial insurance.

Cooperative insurance

In cooperative insurance, a group of subscribers contribute to a pool of funds. Whenever one of the members makes a legitimate claim (relative to the specific form of cooperative insurance to which they subscribed), they draw money out of the pool. In the meantime, the funds in the pool are invested in an Islamic manner, and without exposing the policy holders to any extra significant risk. Unclaimed profits are then distributed among the policy holders. Notice that Al Zuhayli (1997, ibid.) argued that

The difference between commercial and cooperative insurance is that the insurer in the former is not an institution separated from the insured. Moreover, the members of the insuring organization are not seeking to make profits, but only to reduce the losses which affect some of them. In contrast, the insurance in exchange for fixed installments is implemented by an insurer which is a profit seeking corporation. Such profits are made at the expense of the insured...

In fact, this logic is exactly applicable to the distinction between mutual and stock insurance companies as they exist in the U.S. The logic inherent in the above quote (that stock insurance companies seek to make profits at the expense of policy holders, while mutuals provide better insurance) in fact agrees with our most sophisticated economic understanding of the structure and operations of such companies. [Note: The economically oriented reader may consult Mayers and Smith (1988), Smith and Stutter (1995), and the references therein.]

Unfortunately, most of the "cooperative insurance"' companies established in Islamic countries are in fact similar in ownership structure to stock insurance companies. In principle, however, a mutual insurance company which invests its funds in Islamically acceptable ways would satisfy all the conditions put forth by the ,jurists as a valid alternative to commercial insurance. While no Islamic cooperative insurance companies are currently operating in North America, some efforts are underway both in the U.S. and Canada to establish such organizations. Until such a time, Muslims may still reduce risks through direct diversification, and in the absence of permissible insurance alternatives, most jurists agree that the use of available insurance vehicles becomes temporarily permissible if needed or required by law.