Islamic Financing
AN ALTERNATE FINANCING TECHNIQUE
SAHEEBA SABAKKA
ISLAMIC FINANCING
AN ALTERNATE FINANCING TECHNIQUE
A PROJECT REPORT Under the guidance Of
Mrs. Neena P. G
Submitted By
SAHEEBA SABAKKA
Roll No. 510915516
In partial fulfillment of the requirement For the award of the degree
Of MBA
in FINANCE
ACKNOWLEDGEMENT
I express our deepest gratitude to our Advisor and Counselor
Mrs. Roshini P. K, for her invaluable guidance and blessings.
I am very grateful to our Principal and Head of Department Mr.
Vinod C. T for providing with an environment to complete this project
successfully. I especially thank Project Coordinator Ms. Neena for all the support she had extended to complete the project.
I express our sincere thanks to Mr. H. Abdul Raqeeb Jeneral
Secretary ICIF, for his constant encouragement and support throughout
the course of the project. I am immensely grateful to Mr. Abdussalam
K. M Trustee ICIF, for his unwavering support throughout the entire
course of the project. I would also like to thank all the staff at ICIF who have co-operated with me for the completion of this project.
I would also like to thank Ms. Gopika and all other staff at Mercy Institute of Technology who have extended their help and support throughout the project.
Finally, I take this opportunity to extend our deep appreciation to our family and friends, for all that they meant to us during the crucial times of the completion of our project.
BONAFIDE CERTIFICATE
Certified that this project report titled “ISLAMIC FINANCE” is the bonafide work of “SAHEEBA SABAKKA” who carried out the project work under my supervision.
SIGNATURE SIGNATURE
Vinod C. T Neena P. G
HEAD OF THE DEPARTMENT FACULTY IN CHARGE
MBA MBA
Mercy Institute of Technology Mercy Institute of Technology
Punnathoor Rd. Punnathoor Rd.
Puthanpally (P. O) Puthanpally (P. O)
EXECUTIVE SUMMARY
Uncontrolled capitalism has caused the global economy into a plunge into an unprecedented crisis. Adding to the distress, economists worldwide are expecting the global economy to experience a double dip in the near future. This calls in for a need for eradicating huge bubbles of fiat money and assets brought in by capitalism and build up a real and stable economy.
In this project, we try to study Islamic banking and financing as an alternate mode of financing as a remedy. In the wake of crisis, world has slowly started to shifting to this alternate financing model which offers a wide range of complexly engineered tools viz., Mudaraba, Murabaha, Musharaka, Istisna, Musaqat, Ijara and a lot more as has been discussed in the upcoming chapters. Salient features of each have also been studied.
Though Islamic financing has been creating waves in the global economy, it is yet to unveil in our much potential Indian economy, owing to its non-consonance with the prevailing provisions of Banking Regulations Act. Even though remedies are available as has been studied in the project, our Central Bank is yet to sanction this model of financing which promises a new era of bright future for Indian economy.
TABLE OF CONTENTS
1. INTRODUCTION
1. 1 An Introduction to financial system 1.1.1 Importance of financial system 2.1 Islamic financial system
2.1.1 Need for Islamic banking
2. ISLAMIC FINANCE
2.1 Basic Tenets of Islamic Banking and Finance 2.1.1 Riba
2.1.2 Gharar 2.1.3 Zakaat 2.1.4 Haram
2.2 Principles of Islamic Banking
2.2.1 Prohibition against the payment and receipt of a fixed or pre- determined rate of interest
2.2.2 Sharing risks and rewards
2.2.4 Making money from money is not acceptable 2.3 Islamic Financial Institutions
2.3.1 Islamic Banking
2.3.2 Islamic Insurance (Takaful Institutions) 2.3.3 Investment Banking and Mutual Funds 2.4 Tools and Techniques of Islamic Financing
2.4.1 Murabaha (Cost plus Finance) 2.4.1.1 Steps in Murabaha 2.4.1. 2 Subject of Murabaha 2.4.1.3 Specification of price
2.4.2 Mudaraba (Trustee Finance Contract) 2.4.1 Participatory Financing
2.4.2 Preconditions of Mudaraba Contract 2.4.3 Restricted and Unrestricted Mudaraba 2.4.4 Two tier Mudaraba
2.4.5 Termination of Mudaraba 2.4.3 Musharaka (Joint Venture)
2.4.3.1 Different types of Musharaka 2.4.3.2 Diminishing Musharaka 2.4.3.3 Management of Musharaka 2.4.3.4 Termination of Musharaka
2.4.4 Muzara’at and Musaqat (Agricultural Partnership) 2.4.4.1 Contracting Musaqat
2.4.4.2 Conditions of Musaqat 2.4.4.3 Termination of Musaqat 2.4.5 Ijara (Islamic Lease)
2.4.5.1 Basic Rules governing leasing 2.4.5.2 Types of Ijara
2.4.6 Qard Hassan (Benevolent Loan) 2.4.6.1 Objectives of Qard Hassan
2.4.6.2 Conditions of Qard Hassan Transaction 2.4.6.3 Application of Qard Hassan
2.4.7 Salam or Bai’ Salam (Forward Contracts) 2.4.7.1 Conditions of Salam
2.4.8 Takaful (Islamic Insurance) 2.4.8.1 Principles of Takaful 2.4.8.2 Modules under Takaful
2.4.8.3 Tabarru’ to eliminate Uncertainity 2.4.8.4 Issues in conventional Insurance 2.4.8.5 Distinguishing features of Takaful 2.4.9 Istisna
2.4.9.1 Ways of effecting Istisna Sale Contract 2.4.9.2 Termination of Istisna
2.4.9.3 Istisna as a Deferred Payment Scheme 2.4.9.4 Application of Istisna
2.4.10 Sukuk (Islamic Bonds)
2.4.10.1 Difference between Sukuk and Conventional Bonds
2.4.10.1 Features of Sukuk
2.4.10.2 Uses of Sukuk Funds 2.4.10.3 Types of Sukuk 2.5 Functioning of Islamic Banks
2.5.1 Current Accounts 2.5.2 Savings Accounts 2.5.3 Investment Accounts 2.5.3.1 Equity Fund 2.5.3.2 Ijara Fund 2.5.3.3 Commodity Fund 2.5.3.4 Murabaha Fund 2.5.3.5 Mixed Fund
2.6 Rise and Scope of Islamic Banking 2.6.1 History of Islamic Banking 2.6.2 Growth of Islamic Banking
2.6.3 Reasons for popularity of Islamic Banking 2.7 Viability of Islamic Finance in India
2.7.1 Hurdles on the way of introducing Islamic Banking in India
2.7.2 Risks inherent in Islamic Banking
LIST OF TABLES
Table 1 : Financing Options for Capital Holders Table 2 : Financing Options for Entrepreneurs
LIST OF FIGURES
Figure 1 : Working of Mudaraba
LIST OF ABBREVIATIONS AND NOMENCLATURE SYMBOLS 1. Rs. Rupees 2. & And 3. % Percent 4. @ at the rate 5. $ Dollar 6. i.e that is
7. viz namely/ that is to say
ABBREVIATIONS
8. SRI Socially Responsible Investments 9. SSB Sharia’ Supervisory Board
10. QIB Qualified Institutional Buyers 11. LIBOR London Inter Bank Offer Rate 12. P/L Profit and/or Loss
13. ROSCA Rotating Savings and Credit Association 14. UK United Kingdom
15. PLS Profit Loss Sharing
16. IDB Islamic Development Bank 17. GCC Gulf Cooperation Council
19. USA United States of America 20. BRA Banking Regulation Act 21. RBI Reserve Bank of India 22. IPO Initial Public Offering
NOMENCLATURE
1. Sharia’ (shariah/sharia) Islamic Rules and Regulations
2. Riba Interest
3. Gharaar Uncertainity
4. Zakat Islamic tax
5. Haram Prohibitted/ Unethical 6. bai' bithaman ajil Sales wih advance Payment
7. nisab basic amount excepted out of tax or zakat 8. halal permitted/ encouraged
9. israf wa traf luxurious activity
10. Maisir gambling
11. Murabaha Cost-plus Financing 12. Mudaraba Trustee Finance Contract 13. Rabb ul Mal Owner of the capital 14. Mudarib Fund Manager
15. Mudaraba Al-Mutlaqa Restricted Mudararaba 16. Al-Muqayyada Restricted
17. Musharaka Joint Venture
18. Shirkat-ul-milk Partnership based on joint ownership
19. Shirkat-ul-‘aqd Partnership based on contractual relationship
21. Shirkat-ul-Inan restricted authority and obligation partnership
22. Shirkat-ul-Wujuh goodwill/ credit worthiness partnership
23. Shirkat-ul-Abdan labor, skill and management partnership
24. Mazara'at and musaqat Agricultural partnership 25. Baligh Major/ Mature
26. Ijara Islamic lease 27. Ijara Thumma Al- Baai Hire Purchase
28. Ijara Wa Iqtina A form of Islamic lease 29. Qard Hassan Benevolent Loan
30. Aqil person with sound mind
31. Rashid person capable of sound judgment
32. Ijab offer
33. Qabul acceptance
34. Sanduq Box
35. Amana/Wadia Pure Deposit 36. Salam Forward Contract 37. Bai’ Salam Forward Contract 38. Takaful Islamic Insurace
39. Ra’s ul Mal Islamic Insurance Contributions 40. Retakaful Reinsurance
41. Wakala Islamic Agency Insurance 42. Tabarru’ Contract in writing in Takaful 43. Istisna Manufacture Financing
AN INTRODUCTION TO FINANCIAL SYSTEM
A financial system is a system that allows transfer of money between savers and borrowers. It normally comprises of a set of closely interconnected financial institutions, markets, instruments, savers, practices, transactions etc.
Financial system in the modern day serve as a channel through which household savings are distributed to corporate sector for productive utilization for the ultimate good, consequently, of the economy at large. It allocates investment funds among firms, and allows inter temporal smoothing consumption by household and expenditure by firms. In effect, an efficient financial system is a tool of running the economy smoothly, ensuring stability and growth.
Importance of financial system
• Provides framework for carrying out economic transactions and monetary policies
• Helps efficiently channel savings to investments
• Sound financial system is essential for promoting economic growth.
Sound financial system can be considered as the back bone of a prospering economy. A defective one could reduce effectiveness of monetary policy and deepen or prolong economic downturn. It creates a capital flight ( or large fiscal costs related to rescuing troubled institution) on a large scale. To add to it, in the modern liberal world scenario, weakness of one country can rapidly spill over across national borders and result in a global economic slump as we’ve seen in the recent past. That is to say, a sound financial system is essential for the domestic as well as the countries those that have trade or financial linkages with the country concerned.
Thinkers of the recent and ancient past have devised several forms of financial system to keep large economies on its heels. The most popular of them are capitalistic and communist system of finance, both of which in the present scenario have proven to fail on account the unprecedented economic crisis that the planet plunged into.
This situation calls out for a need for alternative financial system for a healthy and sustainable global economy. Islamic finance is an answer to that quest.
ISLAMIC FINANCIAL SYSTEM
Islamic finance is based on principles of shariah, or “Islamic law.” Major principles of shariah are a ban on interest, a ban on uncertainty, adherence to risk- sharing and profit sharing, promotion of ethical investments that enhance society, and asset backing. The international market for Islamic finance has grown between 10% to 15% annually in recent years. Islamic finance historically has been concentrated in the Persian Gulf countries, but has expanded globally to both Muslim and non-Muslim countries. There is huge and growing market potential for Islamic finance in the India. Through international and domestic regulatory bodies, there has been effort to standardize regulations in Islamic finance across different countries and financial institutions, although challenges remain.
Islamic banking is essentially banking in consonance with the ethos and value system of Islam and governed in addition to the conventional good governance and risk management rules, by principles laid down by Islamic law, Shariah. It is, however, not confined to interest free banking, which is a narrow concept. In addition to non-acceptance of interest-based transactions, the fundamental tenet is that of fairness. It envisages ethical practices, contributions towards a more equitable distribution of income and wealth and active participation in achieving the goals and objectives of an Islamic economy.
The history of non-interest banking in its present day incarnation is of recent origin. In the second half of the 20th century, efforts were made to adopt Islamic finance in Egypt. It slowly spread to Middle East and then to other parts of the world. Today approximately 700 registered Islamic finance institutions are said to exist covering 51 countries. The annual growth rate of Shariah compliant assets is more than 15% on year-to-year basis. At this rate, it is the world’s fastest growing financial sector and is becoming an increasingly important component of the international financial system.
Need for Islamic Banking
The collapse of major Wall Street institutions, notably Lehman Brothers, and the subsequent global financial crisis and economic recession, Islamic banking is seriously being considered and has emerged as a possible alternative to the conventional banking because of the following reasons:
• It is based on Ethical and Socially Responsible Investments (SRI) • It aims at Equity and Justice and leads to poverty alleviation
• It acts to new imension to assets andactual projects aiming to support real economic growth instead of financial engineering • It provides services to under banked populations ignored by
conventional banks
BASIC TENETS OF ISLAMIC BANKING AND FINANCE
The basic tenets of Islamic banking and finance can be put down as under;
1. Prohibition of interest-based (riba) transactions;
2. Ban on speculation and excessive risk taking (gharar); 3. Islamic tax system (zakat);
4. Discouragement of the production of goods and services which contradict the value pattern of Islam (haram)
Riba
Perhaps the most far reaching of these is the prohibition of interest (riba). The payment and acceptance of riba, which are the fundamentals of conventional banking system is explicitly prohibited in Islamic banking and thus investors must be compensated by other means. Technically, riba refers to the addition in the amount of the principal of a loan according to the time for which it is loaned and the amount of the loan. While earlier there was a debate as to whether riba relates to interest or usury, there now appears to be consensus of opinion among Islamic scholars that the term extends to all forms of interest.
In banning riba, Islam seeks to establish a society based upon fairness and justice. A loan provides the lender with a fixed return irrespective of the outcome of the borrower's venture. It is much fairer to share the profits and losses. Fairness in this context has two dimensions: the supplier of capital possesses a right to reward, but this reward should be
commensurate with the risk and effort involved and thus be governed by the return on the individual project for which funds are supplied.
Hence, what is forbidden in Islamic precepts is a predetermined return. The sharing of profit is legitimate and that practice has provided the foundation for Islamic banking.
Gharar
Another feature condemned by Islamic banking is economic transactions involving elements of speculation, gharar. Buying goods or shares at low price and selling them for higher price in the future is considered to be illicit. Similarly an immediate sale in order to avoid a loss in the future is condemned. The reason is that speculators generate their private gains at the expense of society at large.
Under this prohibition any transaction entered into should be free from uncertainty, risk and speculation. Contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions. Also, parties cannot predetermine a guaranteed profit. This is based on the principle of 'uncertain gains' which, on a strict interpretation, does not even allow an undertaking from the customer to repay the borrowed principal plus an amount to take into account inflation. The rationale behind the prohibition is the wish to protect the weak from exploitation. Therefore, options and futures are considered as un-Islamic and so are forward foreign exchange transactions because rates are determined by interest differentials.
A number of transactions are treated as exceptions to the principle of gharar: sales with advanced payment (bai' bithaman ajil); contract to
manufacture (lstisna); and hire contract (jIara). However, there are legal requirements for the conclusion of these contracts to be organized in a way, which minimizes risk.
Zakat
A mechanism for the redistribution of income and wealth is inherent is Islam, so that every Muslim is guaranteed a fair standard of living, nisab. An Islamic tax, Zakat (a term derived from the Arabic zaka, meaning "pure") is the most important instrument for the redistribution of wealth. This tax is a compulsory levy, one of the five basic tenets of Islam and the generally accepted amount of the zakat is one fortieth (2.5 per cent) of Muslim's annual income in cash or kind from all forms of assessed wealth exceeding nisab.
Every Islamic bank has to establish a zakat fund for collecting the tax and distributing it exclusively to the poor directly or through other religious institutions. This tax is imposed on the initial capital of the bank, on the reserves, and on the profits as described in the Handbook of Islamic Banking.
Haram
A strict code of 'ethical investment' is prescribed and hence it is forbidden for Islamic banks to finance activities or items forbidden in Islam, haram, such as trade of alcoholic beverage and pork meat. Investments should only support practices or products that are not forbidden or even discouraged by Islam.
Islamic banks are required to give priority to the production of essential goods which satisfy the needs of the majority of the Muslim community,
while the production and marketing of luxury activities, israf wa traf is considered as unacceptable from a religious viewpoint.
In order to ensure that the practices and activities of Islamic banks do not contradict the Islamic ethical standards, Islamic banks are expected to establish a Sharia Supervisory Board, consisting of Muslim jurisprudence, who act as advisers to the banks.
PRINCIPLES OF ISLAMIC BANKING
Islamic banking has its own unique principles that clearly distinguish it from the rest of the financial system. Principles of Islamic banking and finance are largely value based and as per the guidelines prescribed by the sharia law. These principles form the basis for the tools and techniques of Islamic financing.
Prohibition against the payment and receipt of a fixed or pre-determined rate of interest
The essential feature of Islamic banking is that it is interest free. Islam prohibits Muslims from taking or giving interest regardless of the purpose for which such loans are made and regardless of the rates at which interest is charged. However, the Islamic ban on interest does not mean that capital is costless in an Islamic system. Islam recognizes capital as a factor of production, but does not allow the factor to make a prior or pre-determined claim on the productive surplus in the form of interest. Islam allows the owners of capital a share in the surplus, which is uncertain. Profit sharing permissible in Islam, while interest is not, as in the case of the former, it is only the profit sharing ratio, not the rate of return itself that is pre-determined.
Profit- making is acceptable in Islamic society as long as these profits are not unrestricted or driven by the activities of a monopoly or cartel. Islam deems profit, rather than interest, to be closer to its sense of morality and equity because earning profits inherently involves sharing risks and rewards. Profit making addresses the Islamic ideals of social justice because both the entrepreneur and the lender bear the risk of investment.
Thus the interest is replaced by profit and loss sharing arrangements, where the rate of return on financial assets held in banks is not known and not fixed prior to the undertaking of the transaction. The actual rate of return can be determined only ex-post, on the basis of actual profits accrued from real sector activities that are made possible through productive use of financial assets.
Sharing risks and rewards
The prohibition of a risk free return and permission of trading makes the financial activities in an Islamic set-up real asset-backed with ability to cause 'value addition'. Islamic banking system is based oh risk sharing, owning and handling of physical goods, involvement in. the process of trading, leasing and construction contracts using various Islamic modes of finance.
As such, Islamic banks deal with asset management for the purpose of income generation. They will have to prudently handle the unique risks involved in management of assets by adherence to best practices of corporate governance. Once the banks have stable stream of Halal income, depositors will also receive stable and Halal income.
Permissible forms of businesses
The forms of businesses allowed under Islamic banking include joint ventures based on sharing of risks 8 profits and provision of services through trading, both cash and credit, and leasing activities.
Though the apparent similarity between trade profit in credit sale and Riba in loaning is not denied in literature, trade has been permitted and Riba is prohibited. Profit has been recognised as 'reward' for (use of)
capital and Islam permits gainful deployment of surplus resources for enhancement of their value. However, alongwith the entitlement of profit, the liability of risk of loss on capital rests with the capital itself; no other factor can be made to bear the burden of the risk of loss. Financial transactions, in order to be permissible, should be associated with goods, services or benefits.
Besides trading, Islam allows leasing of assets and getting rentals against the usufruct taken by the lessee. All such things/assets corpus of which is not consumed with their use can be leased out against fixed rentals. The ownership in leased assets remains with the lessor who assumes risks and gets rewards of his ownership.
Making money from money is not acceptable
Money is only a medium of exchange, a way of defining the value of a thing; it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. The human effort, initiative, and risk involved in a productive venture are more important than the money used to finance it.
Muslim jurists consider money as potential capital rather than capital, meaning that money becomes capital only when it is invested in business. Accordingly, money advanced to a business as a loan is regarded as a debt of the business and not capital and, as such, it is not entitled to any return (i.e. interest).
Muslims are encouraged to purchase and are discouraged from keeping money idle so that, for instance, hoarding money is regarded as being
unacceptable. In Islam, money represents purchasing power which is considered to be the only proper use of money. This purchasing power (money) cannot be used to make more purchasing power (money) without undergoing the intermediate step of conversion into kind; i.e. by acquisition of goods and services.
ISLAMIC FINANCIAL INSTITUTIONS
While the Islamic financial institutions started almost fifty years back, the growth was slow in the early stages and it is a system, which is still young, evolving and expanding in terms of innovation and geographical location. It is estimated that as of now there are more than three hundred Islamic financial institutions spread across both the Islamic and non-Islamic countries. Some of the major forms of non-Islamic financial institutions are;
a) Islamic Banking
Islamic banking is the most popular form of financial institution and it is estimated to be into several hundred billion dollars. There are different models of Islamic banking;
wherein the Islamic banking is a private institution with a traditional conventional economy
a nationalized Islamic banking and third is the existence of both the Islamic and conventional banking system running parallel
Many commercial banks have innovated and engineered new products, which have led to their impressive growth. In traditional system, stress is on efficiency and productivity, the basic thrust of an Islamic financial system is ethical code of conduct with an underlying idea of equitable and just distribution of resources to achieve an equitable society.
system. The islamic banking is currently undertake through two channels; • Islamic banks and ;
• Islamic windows.
Islamic banks are purely based on Islamic principle and all their operations are in conformity with sharia. Islamic windows are services provided by the traditional commercial banks to Muslim customers who engage in Islamic banking through exclusive window.
b) Islamic Insurance (Takaful Institutions)
Risk sharing and management is an important constituent of any financial system. There are scholars who believe that insurance can never find place in an Islamic financial system as a Muslim should be dependent upon God and getting insured amounts to challenging the will of Allah. But there is another school of thought, which believes that a Muslim should take all precautions to mitigate the risk and then not worry about the outcome and leave it to the wilt of Allah.
The traditional concept of insurance is considered to be Maisir (gambling) and a contract, which has lot of gharar (uncertainty), Islamic insurance is based on takaful wherein every person participating gives a donation or tabarru, all these donations together constitute the fund from which any participant that suffers a loss or damage gets reimbursement. The balance amount, if any, left in the fund is returned back to the participants.
c) Investment Banking and Mutual Funds
The conventional investment banking deals with raising capital for a business either through sale of shares to the public or allotting the shares to certain Qualified institutional Buyers (QIB). Investment banks also
create venture capital funds wherein they provide seed capital for the start-up business growth stages of the business.
An investment banker raises money through equity, debt and other investments like derivatives. An islamic investment banker cannot deal in debt instruments and derivatives. In case of equity and preference shares, the majority of islamic scholars permit it on the ground that it involves pro rata ownership of assets of the company. But the investment bankers must deal with only those companies, which are engaged in sharia
compliant business.
Venture capital financing by investment bankers should be after fully appraising and evaluating the venture, which will eliminate uncertainty (gharaar) and therefore permissible. Investment in the form of venture capital without analyzing the business proposition is outside the preview of an Islamic investment banker as it has lot of uncertainty involved in it.
Dealings in the secondary market by fund managers, which are purely speculative in nature, are un-Islamic. The pre-condition for Islamic mutual funds is that there can be no assured profits and the profits and losses from the investment of the pooled funds will have to shared on a pro rata basis.
Though this type of fund resembles a traditional mutual fund but the funds have to be invested in a company only if it fulfills certain conditions prescribed in the sharia laws.
must be halal that is, it should not be dealing in business like pork selling, liquor, gambling.
Secondly, the company should not be using debt, in other words having no borrowed money on which it is paying interest and it should not be keeping its money in a bank, which pays interest on these deposits.
These two conditions, especially the second one about interest on deposits and borrowings make it almost impossible for the followers of Islam to invest their money in stock markets through pooled funds.
However, certain scholars have advocated that if the business of the company is halaal and it is a zero debt company and it receives a small amount from its deposits with banks, then if an investor who receives dividends, gives away that part of the dividend which is attributable to the interest on deposits, then such income will be considered ha1al.
Thirdly, the shares of company can be purchased only if the company holds a combination of liquid and illiquid assets.
If all the assets are in money then the shares will have to be purchased at par. There has been a huge growth in Islamic equity funds and there are islamic indexes, one of the popular ones is the Dow Jones islamic index. Even though a fund may be tracking an Islamic index, this by itself does not make the profits fully sharia compliant.
TOOLS AND TECHNIQES OF ISLAMIC FINANCING
In order to cater to the needs of the modern world, Islamic financing puts forwards a wider range of tools and techniques of financing. These while ensuring to meet the needs of the financial world, also takes care to adhere to rules of sharia, which is primarily staying off interest system. As per the rules of sharia, any addition to the principal amount which adds up without creation of real wealth amounts to riba. That is to say, the amount earned without sharing of risks or losses would in effect amount to riba.
Engineers of Islamic financing tools have been careful enough to meet up the requirements of its tenets and basic principles. In effect, what they put forward to us is a wide range of new techniques of financing which are complex in its very own nature and application. At the same time, there’s ease and simplicity at the side of the customer of the banker.
Islamic financial tools function basically on; 1. Profit sharing (mudaraba)
2. Buy and sell back (murabaha) 3. Venture Capital (musharaka)
Many tools might resemble the conventional tools of financing as they might look, but might differ in it simply because it don’t cater to riba.
A wide range of tools and techniques of Islamic financing has been listed in the upcoming chapters.
MURABAHA (Cost Plus Finance)
Murabaha is a form of cost plus or mark up financing where an asset id acquired by the bank and sold to the customer. No money is loaned to the client. Rather, the financing party purchases the goods himself, based on the requirement of the client. This ensured that financing is always asset-based. In effect, this type of financing creates real assets and inventories. It is understood that most of the financing operations in Islamic banking are based on Murabaha.
Steps in Murabaha
1. The client indicates an interest in purchasing a particular asset from the bank for a certain price (a combination of cost price plus profit) at a certain time (the utilization date).
2. The client identifies the vendor, selects the goods and advises its particulars, including the vendor's name and its cost price to the bank in writing. Often the bank will appoint the client as its wakil (agent) to acquire the asset on the bank's behalf.
3. The bank acquires the asset and offers to sell it to the client. The vendor will typically make delivery of the asset to the client (as the bank's agent). Delivery need not be physical; it can also be constructive (i.e. evidenced by delivery of documents of title). 4. The agency contract comes to an end. The client accepts the offer
valid sale contract, with payment due on the agreed date in the future.
Fig 1: Working of Murabaha
Subject of Murabaha
The assets (mal), which are the subject of the sale, must fulfill the following requirements:
• The subject of sale must exist and be in the ownership (physical or constructive) of the bank at the time of sale. In other words, the second contract must "follow" the first contract. This risk- bearing by the bank - even if for a short or fleeting time period - legitimizes banks' profits under Shari'ah as distinct from prohibited riba.
• They must be something of value that is classified as property in fiqh (Islamic jurisprudence) and must not be forbidden commodities, such as alcohol, pork etc.
Specification of price
The sale price and payment terms must be known. The price is fixed at the time of contracting, as is the mode of payment, e.g. frequency and quantum of installment payments. This is to avoid any gharar or uncertainty. Where the sale price includes a known profit or mark-up, the profit rate can be determined or expressed in relation to the market interest rate such as LIBOR. The price may not always be specified in the main murabaha documentation but can often be the subject of side letters/agreements between the parties.
MUDARABA
(Trustee Finance Contract)
Mudaraba is essentially an agreement between a financier and an entrepreneur — the principals. It is a contract whereby one side the investor or Rabb ul Mal contributes money and the other side work, being the manager or Mudarib. The Rabb ul Mal bears all losses, and the Mudarib earns a profit share. Mudaraba is a concept to provide capital to somebody undertaking the work. It could be understood as being similar to the function of an asset manager or employed manager of a company.
Participatory Financing
The central idea in the concept of mudaraba is that two parties, one with capital and the other with know- how, get together to carry out a project. The financier provides the capital and plays no further part in the project; specifically, he does not interfere in its execution, which is the exclusive province of the entrepreneur.
If the project ends in profit they share the profit in a pre-arranged proportion. If it results in loss the entire loss is borne by the financier, and the entrepreneur gains no benefit out of his effort, which was his part of the investment. However, in cases of proven negligence or mismanagement by the entrepreneurs, they may be held responsible for the financial loss incurred.
Mudaraba is usually translated as profit-and-loss-sharing but, as far as the financier is concerned, it is in fact profit-sharing-and-loss-absorbing.
Preconditions of Mudaraba contract
1. The financial risk is entirely and exclusively born by the banker, and as such there’s no scope for reducing credit risk by requesting collateral security.
2. The rate of profit should be determined strictly as a percentage and not as a lumpsum.
3. The entrepreneur has absolute freedom to manage the business.
Restricted and Unrestricted Mudaraba
Where the capital is provided as being unrestricted for any purpose the manager deems fitting is called Unrestricted Mudaraba or ‘al-mudaraba al-mutlaqah’.
The banker may also grant it upon conditions what has to be made with it which would then constitute what is called Restricted Mudaraba (Mudaraba al Muqayyadah), e.g. all investment funds.
Two -Tier Mudaraba
The structure of Mudaraba transactions is such that the banker is involved in two different mudaraba transactions, and hence the name two-tier mudaraba. The first Mudaraba is between the bank and the client with surplus capital (depositors) and the second one is between the bank and the clients who require financing.
The first tier Mudaraba between depositors and the Islamic has those depositors acting as Rabb ul Mal and the bank acting as the Mudarib. The depositors place their funds with the bank with no guarantee of principal and a return based on the profitability of the investments made by the bank on their behalf. As with other Mudaraba, the depositors bear any losses and share profits with the Islamic bank according to a pre-agreed ratio.
The second tier Mudaraba between the Islamic bank and those receiving financing has the bank acting as Rabb ul Mal and the customers acting as Mudarib. The bank bears all losses except in cases of fraud by the Mudarib and share profits with the customer according to a pre-agreed ratio.
Table No. 1
Investment options of capital- holders Type of Investment Mode of Investment Type of return on Capital Rule Active investment In own enterprise
Profit or Loss from the
enterprise Allowed
Shares in a Company
Dividend (P/L) from the
company Allowed
Bonds/
securities Fixed positive return (riba) Prohibitted Passive
investment
Table No. 2
Financing options for entrepreneurs Type of financing Mode of financing Type of return on Capital Rule Active
finance Own funds
Profit or Loss from the
enterprise Allowed
Share Capital Dividend (P/L) from the
company Allowed
Bonds/ securities
Fixed positive return
(riba) Prohibitted
Passive finance
Bank loans Fixed positive return
(riba) Prohibitted
Termination of Mudaraba
The contract of Mudaraba can be terminated at any time by either of the parties. The only condition is to give a notice to the other party. If at the time of termination, assets of the mudaraba are not in cash form, the mudarib shall be given an opportunity to liquidate them so as to determine the amount of profit, which shall then be divided as per the agreed ratio.
MUSHARAKA (Joint Venture)
Musharaka is a contract whereby the bank and a customer agree to combine their financial resources for the establishment or running of a business or project, or for undertaking any type of business activities. The two parties agree to manage the project in accordance with the terms of the contract.
The profit or loss will be apportioned between the parties, according to a mutually agreed proportion, which need not coincide with the ratio of amount of capital invested. Losses are shared by all parties in proportion to their investment. Banks have a legal authority to participate in the management of the project, including representation on the Board of Directors.
Different types of Musharka
There are two basic types of Musharaka;
1. Shirkat-ul-milk (Partnership based on joint ownership) – This a voluntary Musharaka, which come into existence at the option of the participants.
2. Shirkat-ul-‘aqd (Partnership based on contractual relationship) – This partnership is based on contractual relationship.
1. Shirkat-ul-Mufawadah (full authority and obligation) – This is a limited partnership with equal capital contributions, responsibility, full authority on behalf of others, along with responsibility for liabilities incurred through the normal course of business.
2. Shirkat-ul-Inan (restricted authority and obligation) – This too is a limited form of partnership, but with unequal capital contributions. They do not share equal responsibility, and this reflects their share of profits.
3. Shirkat-ul-Wujuh (goodwill/ credit worthiness) – This is a kind of partnership entered into with companies based on reputations of one of both parties, typically small scale business.
4. Shirkat-ul-Abdan (labour, skill and management) – Partnership with a company based on the contribution of human efforts with no capital contributions. These are again typically small scale business.
5. Shirkat-ul-Mudaraba – This is a partnership for a Mudaraba contract.
Diminishing Musharakah
This is a derived form of Musharakah and was developed in the near past. According to this concept, the financier-and the client participate either in the joint ownership of a property or an equipment, or in a joint commercial enterprise, on a diminishing share basis. The share of the financier would be divided into a number of units and the contract is on a condition that the client purchases the units of the share of the banker one by one periodically, thus increasing his own share till all the units of the financier are purchased by him so as to make him the sole owner of the property, or the commercial enterprise, as the case may be. At the same
time, the share of ownership of the financier in the property keeps diminishing and hence the name ‘Diminishing Musharaka’.
Table No. 3
An example of Payment Schedule under Musharaka
Month Rent (Rs.) Extra Payment (Rs.) Total Fixed Payments (Rs.) Bank’s ownership (Rs) opening 120000 1 800 347 1147 119653 2 789 349 1147 119304 …. ….. ….. 1147 … 176 37 1110 1147 4439 177 30 1117 1147 3322 178 22 1125 1147 2197 179 15 1132 1147 1065 180 7 1065 1072 0
Management of the Musharaka
Every partner has a right to take part in the management and to work for it. However, the partners may agree upon a condition that the management shall be carried out by one of the and not by other partners. In that case, the sleeping partner should be entitled to the profit only to the extent of his investment, and the ratio of the profit allocated to him should not exceed the ratio of his investment.
Termination of Musharaka
Every partner has a right to terminate the Musharaka at anytime after giving his partner a notice to this effect, whereby the Musharaka with come to an end. Termination of one partner need not terminate the whole agreement and others may purchase the terminating partners share and continue the business.
MAZARA'AT AND MUSAQAT (Agricultural Partnership)
Mazara'at and musaqat are two types of partnership. They are similar to mudarabah, in that they are both types of partnerships between capital and labour. The difference is that mudarabah is relevant to trading whereas muzara'at is for farming.
If a person leaves his trees with someone for a specified period of time, so that he cares, tends and waters them, and in return, that person will take an agreed quantity of fruits, this transaction is called Musaqat.
In partnerships between capital and labour, whether mardarabah agreements or mazara'at or musaqat, any kind of harm or loss the capital is subject to is born by the owner of the capital, the investor. And, as such, there is also no certainty of making a profit on the capital. The only profit that is returned to the owner of the capital is in accordance to the profit made by the partnerships and to his specified proportion of those profits. Here it is that the financer, just like the worker, might make no profit, and it is even possible that he may lose his capital and even become bankrupt.
Contracting Musaqat
While concluding a transaction of Musaqat, the prescribed formula can be recited in any language, or without reciting the formula, if the owner of trees hands over them, with the intention of Musaqat, to the person who
has agreed to take care of them, and he also receives them with the same intention, the transaction will be in order. (Of course, the necessary talks about the duration and the conditions, etc. should have taken place earlier).
The following points need to be considered;
1. If a clear agreement, in respect of melon, cucumber vines etc., in which the number of times of picking and the share of each one are specified, is made.
2. Trees that need not be irrigated and benefit from rainwater or the moisture of the earth, but need other work to be done for them, like turning up with a spade, fertilizing and spraying which will make their fruits or their quality to be increased, it will be in order.
3. The work to be done by each of the parties involved should be specified in advance, like, repairing the subterranean canals, or the water well engine, also the supply of the manure, spray equipments, etc., and if there is a local practice and rule in this respect, that will suffice.
4. It is possible that the other party in Musaqat be more than one, that is, the owner of the trees may leave them in the hands of several people, and conclude the contract of Musaqat with them.
Conditions for Musaqat
1. The owner of the trees and the person who undertakes to tend and care for them, should be Baligh and sane.
2. No one should have compelled them to do so.
their own property.
4. The period of Musaqat should be specified, and if the beginning of it is specified, and its end is fixed to be the time when fruits for that year become available, the contract is in order.
5. It is necessary that the share of each one of them be fixed as 1/2 or 1/3 etc. of the crop.
6. It is necessary that the contract of Musaqat be concluded before the appearance of the crop. And if the contract is made after the appearance of the fruits and before they are ripe, the contract will be in order, provided that some work like, watering and spraying which are required for increasing the crop and protecting the trees, still remain to be done. And if the work required to be done, is merely plucking the fruits and looking after them, the contract is in order but it is not Musaqat.
Termination of Musaqat
The parties involved can cancel the transaction of Musaqat with mutual consent, and also if, when concluding the contract, they had agreed that one or both of them would have the right to cancel it, then, he can do so according to the agreement. And if in the contract of Musaqat, they had laid a condition and that condition is not fulfilled, and if the person who benefits from the condition is not able to compel the other party to fulfill it, then, he can cancel the transaction.
The Musaqat transaction will not terminate with the death of the owner of the orchard, and his heirs will act on his behalf. However, if the person who has undertaken to look after the trees, dies and if they had agreed
that he himself would do the job, the contract will become cancelled, but if they have not laid such a condition, his heirs will take his place.
IJARA
(ISLAMIC LEASE)
Ijara is an agreement wherein the Bank leases movable and immovable assets to its customers, with the option that the customer may or may not own the leased asset at the end of the term of the lease as per the agreement singed between the two parties. Ijara means lease, rent or wage.
Basic rules governing Leasing
1. Contract should be for an agreed period, at an agreed consideration; determined at the time of contract.
2. The consideration should in monetary form.
3. The object being leased must have a valuable use; and it should not be perishable.
4. The leased asset should remain in the ownership of the lesser; only its usage is transferred to the lessee
5. All the liabilities arising out of the ownership shall be borne by the lesser, but the liabilities arising from the use of the property shall be borne by the lessee.
6. The lessee cannot use the leased asset for any other purpose than specified in the agreement.
7. Damages to the asset owing to misuse or negligence shall be borne by the lessee asset caused by any misuse or negligence on the part of the lessee; whereas that which is beyond the control of lessee
shall be borne by the lesser.
8. A property under joint ownership can be leased out and the lease amount distributed between the owners In proportion to their shares in the property.
9. The leased asset should be fully identified by all the parties.
10. If variable rentals are fixed different phases, the particulars should be agreed upon at the time of the lease; else the agreement would not be valid.
11. The lease period commences on the delivery of the asset.
12. If the leased asset loses the function for it was leased, provided it can’t be repaired and it didn’t occur due to negligence on part of the lessee, the lease is terminated.
Types of Ijara
Ijara Thumma Al- Baai’ (Hire Purchase)
These are variations on a theme of purchase and lease back transactions. There are two contracts involved in this concept. The first contract, an Ijarah contract (leasing/renting), and the second contract, a Bai contract (purchase) are undertaken one after the other. For example, in a car financing facility, a customer enters into the first contract and leases the car from the owner (bank) at an agreed rental over a specific period. When the lease period expires, the second contract comes into effect, which enables the customer to purchase the car at an agreed price. In effect, the bank sells the product to the debtor, at an above market-price profit margin, in return for agreeing to receive the payment over a period of time; the profit margin on the lease is equivalent to interest earned at a fixed rate of return.
Ijara- Wal- Iqtina
A contract under which an Islamic bank provides equipment, building or other assets to the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or the promise does not become an integral part of the lease contract to make it conditional. The rentals as well as the purchase price are fixed in such manner that the bank gets back its principal sum along with profit over the period of lease.
QARD HASSAN (Benevolent Loan)
Islam allows loan as a form of social service among the rich to help the poor and those who are in need of financial assistance. Loan in Islam may be obtained in two ways: (i) Loan with condition of repayment, and (ii) gratuitous loan without any compensation or gift. However, Islam does not recognize any loan with interest for the benefit of the debtor. It only recognizes gratuitous loan or better known as al-qard al-hasan.
M. Umer Chapra has given the definition of qard al hasan as: "Qard al-hasan is a loan which is returned at the end of the agreed period without any interest or share in the profit or loss of the business." Therefore, qard al- hasan is a kind of gratuitous loan given to the needy people for a fixed period without requiring the payment of interest or profit. The receiver of qard al-hasan is only required to repay the original amount of the loan.
Objectives of Qard Hassan
1. To help the needy fellow people.
2. To establish better relationship among poor and the rich. 3. The mobilization of wealth among all people in the society. 4. To strengthen the national economy.
5. To facilitate the poor to create new jobs market and business ventures by using their merits, skills and expertise.
7. It can remove social and economical discrimination from the society.
8. To eradicate unemployment problem from the society.
Conditions of Qard Hassan Transaction
1. Both parties should be legally (shari'ah) capable to enter into the qard contract
It is unanimously agreed by the four schools of law that to enter into a contract, parties should be baligh, 'aqil and rashid (major with sound judgment). The age of marriage and the sound judgment is the age of majority, and thereby a major person is capable to enter into any transaction validly. A person, who has not attained the age of puberty , may not be a responsible party for al-qard al- hasan transaction.
2. Ijab (offer) and qabul (acceptance) of the qard must be clearly made before entering into the loan contract
Ijab and qabul should be clearly indicated in the contract, otherwise, the loan contract may create dispute in future. In the loan agreement, there should have clear expression, collation and conjunction of the ijab and qabul between the parties.
3. The date of payment must be specified
The date of payment should be mentioned in the loan agreement. If no date is specified, the transaction may lead to ambiguity and dispute in future between the lender and the borrower.
4. The loan contract should be written down
In order to avoid chances of any future dispute, it is necessary that the contract be made in writing.
However, some opine that it is not obligatory but strongly recommended. The reason given by them is that if both parties agree not to write, then it is no longer an obligation upon them to write down. The reason behind the writing down is to avoid future dispute. On the contrary, a minority of the scholars are of the opinion that it is obligatory upon the parties to write down the contract.
5. Getting two witnesses
There must be two male witnesses to make any contract valid. Witnesses are of great importance in sharia compliant contracts. If two men are not available, then one man and two women will suffice. This will help avoid any chance of future disputes which disrupt the whole functionality of Qard Hassan.
6. Administrative fee / Service charge
To obtain some compensation for offering al-qard al-hasan facilities, the banks demand some charges and fees. These expenses incurred by banks on providing al-qard al- hasan are collected from the borrowers, and the basis for the calculation of these expenses is laid down by the central bank.
If any bank or other institutions give al-qard al-hasan, they may require service charge or administrative fee. However, there is no scope for an
individual lender to demand this charge unless any amount incurred due to procedural requirements of the loan agreement, such as lawyer's fee, stamp duty etc.
7. Extra Payment
It is very clear that in the loan agreement, there will be no condition for extra payment, otherwise, it will be riba . It is however, permissible for the debtor to give some sort of gift to the creditor as a sign of appreciation of his voluntary deed.
It is exclusively up to the borrower whether to pay extra or not, regardless the loan was for consumption or commercial purpose and the lender cannot demand it, as it is only a virtue on part of the borrower on repayment and not a right of the lender. Added, there should not be any stipulation for extra benefit in the loan agreement.
8. Early demand to pay back
Loan is a voluntary act by the creditor. However, it is not encouraged for early demand to pay back the loan from the debtor. The creditor should not demand the loan amount from the debtor before the agreement matures or lapses.
9. Guarantors:
In the case of the al-qard al-hasan, there can be guarantors. The guarantors of the borrower may be any person or the property of the borrower that is collateral security, such as, mortgage, charge etc. In case of the borrower's failure to pay back the loan after the expiration of the
time specified, his guarantor has to pay or the collateral security is to be valued for the repayment of the loan. But, Muslims should remember that a true believer should not delay to pay back his obligations.
Application of Qard Hassan 1. Friends and Families
The application for interest free loans is relevant especially among larger families, which may put in place a private “box” called Sanduq among them where needy family members could draw out an interest free credit. Wealthy member may draw out a finance facility against profit/loss sharing explained later on.
2. Qard Hassan for Deposit Taking
Islamic banks to provide finance do not use the instrument of Qard Hassan widely, rather it is used to accept deposits. Such a deposit loan is permissible and could be used to be invested in other projects of the bank, while a pure deposit (Amanah / Wadiah) is cannot be used in the same way.
3. ROSCA - Rotating Credit and Saving Associations
Another potential application for the Qard Hassan technique is the savings/lending model. The loan depositor receives instead of interest, saving points for the size and duration of the funds provided. After achieving a sufficient number of those points, he should able to take out a
loan himself. The administration of such a model could be subject to fees which are not bound by time and size of the credit.
Another positive factor to be seen is the effect of a stress test for the borrower – having savings over a period time is a good way to know the own repayment capacity. Further a credit history is no longer an absolute must. It is a called in the conventional sector a rotating savings and credit association (ROSCA ), and reported to be practiced in the informal sector even in UK and Australia but not on a professional basis.
SALAM or BAI’ SALAM (Forward Contracts)
Salam or Bai'Salaam as it is also called, is a sale whereby the seller undertakes to supply some specific goods to the buyer at a future date in exchange for a price fully paid in advance. It is similar to a forward contract with the buyer paying the seller, the negotiated price of a product that the seller promises to deliver at a future date. The quality and quantity of the products involved in this type of transaction must be capable of being specified at the time of the contract.
Condition of Salam
• The buyer should pay the price in full to the seller at the time of effecting the sale. Else, it will be tantamount to a sale of debt against debt, which is expressly prohibited. Moreover, the basic wisdom behind the permissibility of Salam is to fulfill the instant needs of the seller. If the price is not paid to him in full, the basic purpose of the transaction will be defeated.
• Salam can be effected in those commodities only whose quality and quantity can be specified exactly. For example, the precious stones cannot be sold on the basis of Salam, because every piece of precious stones is normally different from the other and their specifications need to drawn differently.
• Salam cannot be effected on a particular commodity or on a product of a particular field or farm. Because it is possible that field is destroyed before the delivery, and in the presence of this possibility the delivery remains uncertain.
• The same rule is applicable to every commodity whose supply is not certain. It is necessary that the quality of the commodity be fully specified leaving no ambiguity that may lead to dispute.
• It is a necessary that the quantity of the commodity be agreed upon in unequivocal terms.
• The exact date of delivery must be specified in the contract.
• Salam cannot be affected in respect of those commodities that must be delivered at the spot. For example, if gold is purchased in exchange for silver, it is necessary, according to Shariah, that the delivery of both be simultaneous. Here, Salam cannot work.
• Salam sale is not permissible on existing commodities because damage and deterioration cannot be assured before delivery on the due date.
• Salam is permissible on a commodity of a specific locality, if it is assured that it is almost always available in that locality and it rarely becomes unavailable.
• The place of delivery must be stated in the contract, if the commodity needs loading or transportation expenses.
• It is not permissible for the buyer of a Salam commodity to sell it before receiving it because that is similar to the prohibited sale of debts before holding.
• Salam sale is suitable for the finance of agriculture operations, where the bank can transact with farmers who are expected to have the commodity in plenty during harvest either from their own crops or crops of others, which they can buy and deliver in case their crops fail.
• Salam sale is also used to finance commercial and industrial activities, especially phases prior to production and export of commodities and that is by purchasing them on Salam and marketing them for lucrative prices.
TAKAFUL (Islamic Insurance)
Takaful is an Arabic word which means “guaranteeing each other” or joint guarantee as against guarantee or mutual security. Takaful or Islamic Insurance is basically based on the concept of mutual or cooperative insurance and it takes care of all the Shariah related concerns including ensuring investment to be made in Shariah compliant instruments.
The concept of Takaful as such is not new in Islamic Commercial Law. Islam accepts the principle of reciprocal compensation and joint responsibility. The system of Takaful insurance tends to achieve self- reliance through a self-sustaining insurance system based on community pooling, solidarity and joint guarantee for the well being of community and individuals in need, the entire system and operation being based on Islamic principle.
Principles of Takaful
• Policyholders cooperate among themselves for their common good. • Every policyholder pays his subscription to help those that need
assistance.
• Losses are divided and liabilities spread according to the community pooling system.
• Uncertainty is eliminated in respect of subscription and compensation.
Modules under Takaful
1. Mudaraba - By this principle, the entrepreneur or al-Mudharib (takaful operator) will accept payment of the takaful installments or takaful contributions (premium) termed as Ra's-ul-Mal from investors or providers of capital or fund (takaful participants) acting as Sahib-ul-Mal. The contract specifies how the profit (surplus) from the operations of takaful managed by the takaful operator is to be shared, in accordance with the principle of al-Mudharabah, between the participants as the providers of capital and the takaful operator as the entrepreneur.
2. Wakala - Here the Takaful provider act as an agent for the participants and manages the Takaful/Retakaful (Reinsurance) fund for a fee. This model is generally used in middle-east region.
3. A combination of both Mudaraba and Wakala
Tabarru’ to eliminate uncertainity
Takaful companies normally divide the contributions into two parts, 1. Donations for meeting mortality liability or losses of the fellow
policyholders.
2. Investment fund to be invested in halaal business on a non-interest basis.
Accordingly, the clause of Tabarrú is incorporated in the contract. How much of the contribution is meant for mortality liability and how much for investment account is based on a sound technical basis of mortality tables and other actuarial requirements. Both the accounts are invested
and returns thereof distributed on Mudarabah principle between the participants and the Takaful operators. The profit attributable to the participants is credited into the two accounts separately.
Issues in Conventional Insurance
1. Riba (interest) – Conventional life insurance schemes can be considered to contain riba in that the claim is much higher than the premium amount paid. As about general insurance, the fund is invested in instruments that are interest based.
2. Maisir (gambling) – There can be cases where there’s no claim and the policy holder loses all money, and where there’s claim, its much higher than the amount contributed and hence gambling. Life insurance as such is a contract of wager on the death of the policy holder.
3. Gharaar (uncertainty) – The benefits on insurance are dependent upon the outcome of a future event, which is uncertain. Conventional insurance in itself is a game of uncertainty.
Distinguishing features of Takaful
1. The policyholders are the participants to the Takaful / Retakaful fund
2. The contribution so received are not aimed at making profit per se but are more in the nature of pooling the risk and risk management rather than risk taking.
3. The Takaful operator is not the owner of the fund but merely its custodian.
4. The surplus generated belongs to the contributor (i.e. policyholders) solely under wakala model and to both i.e. policyholder and Takaful Company under mudarba model. This is a unique feature of Takaful insurance
5. Since the surplus goes back to the participants in proportion to their contribution, there is an inbuilt check on over-pricing.
6. Funds are invested in Shariah compliant instruments / avenues. 7. Incidentally, Reliance Life has come out with a plan called RSIP
where the investment is made in non-banking sector excluding liquor, cigarette, tobacco, entertainment, gambling, etc.
