Takaful - Role of Insurance in the Financial System

Origins of Risk Pooling

• In early communities, members supported one another during times of hardship or disaster.
• This was an early form of risk pooling.
• Communities could consist of:
• Members of a tribe
• Members of a profession
• Other organised groups
• When one member suffered a loss, the community collectively helped that person recover.
• Over time, this concept of mutual support became commercialised through insurance.

1. Role of Insurance in Trade and Commerce

• Insurance plays an important role in supporting modern trade and commercial activities.
• Some activities may not be possible without adequate insurance protection.
• Examples include:
• Aviation, where aircraft generally require insurance coverage before operating
• Shipping, where goods and raw materials transported by sea require suitable insurance
• Insurance protects businesses against the financial risks arising from commercial activities.
• Historically, trade and commerce were among the main factors that encouraged the development of insurance.

2. Role of Insurance in Finance

• Banks and other financial institutions often require borrowers to have insurance.
• For example:
• Mortgage lenders may require insurance before financing a property
• Businesses using external financing usually maintain appropriate insurance coverage
• Insurance helps reduce the risk of loan default if insured property or a business is damaged or destroyed.
• It benefits both parties:
• Lender: increases the likelihood that outstanding loans can be repaid
• Borrower: receives financial assistance to rebuild property or restart the business

3. Mandatory Insurance

• Some forms of insurance are required by law.
• Common examples include:
• Motor insurance
• Workers’ compensation insurance
• Mandatory insurance helps protect third parties and employees from losses arising from injury or negligence.
• It ensures that compensation is available when the insured becomes legally liable.

4. Insurance for Family and Business Stability

• Insurance acts as a financial safety net when unexpected risks occur.
• Life insurance can provide financial support to a family when its main breadwinner dies.
• It helps replace the immediate loss of household income.
• Businesses may also use key person insurance.
• Key person insurance provides financial protection when an important employee or business leader dies.
• This can help the business:
• Continue its operations
• Reorganise its activities
• Recover from the loss of critical personnel