Takaful - The Role of Insurance in Finance

Insurance plays an important role in financing because banks and other institutional lenders usually require borrowers to maintain adequate insurance coverage on assets that are financed or used as security for a loan. This requirement helps protect both the lender and the borrower against financial losses that may arise if the insured property or business is damaged or destroyed.

For example, when a bank provides mortgage financing for the purchase or construction of a building, it may require the borrower to provide proof of insurance before the financing is approved or released. The purpose is to ensure that the property securing the financing is financially protected against specified risks.

Insurance is also particularly important for businesses that depend on external financing. If a financed building, factory, equipment, or other business asset is damaged by fire or another covered peril, the business may suffer significant financial loss and may no longer be able to generate enough income to meet its financing obligations.

The role of insurance in this situation is to reduce the risk of non-repayment by providing compensation for covered losses. The compensation can help repair or rebuild the damaged property, replace affected assets, or support the recovery of the business. This improves the likelihood that the borrower can continue operating and meeting its financial commitments.

The arrangement benefits both the financier and the borrower. The lender has greater protection over the outstanding financing because the insured asset has financial protection, while the borrower receives assistance to recover from the loss and restore the property or business.

In Islamic finance, takaful can provide the same protective function in a Shari’ah-compliant manner. Instead of relying on conventional insurance, the borrower may participate in an appropriate takaful scheme. Participants contribute to a common fund, and financial assistance is provided from the fund when a covered loss occurs.

Example – Financing of a Commercial Building

A business obtains RM2 million in financing from an Islamic bank to purchase a commercial building. As part of the financing arrangement, the bank requires the business to obtain property takaful protection for the building.

Who is covered?

The business owner or borrower is the takaful participant whose property is protected. The financing bank also has a financial interest in the property because it has provided financing secured against the building.

What is covered?

The takaful protection may cover the commercial building against specified risks such as fire, lightning, explosion, storm, flood, or other covered perils, depending on the terms and conditions of the takaful certificate.

Practical Example:

Suppose the commercial building is seriously damaged by a covered fire while the borrower still owes RM1.5 million to the bank. The takaful fund may provide compensation according to the terms and limits of the certificate. The compensation can help repair or rebuild the building and protect the financial interests of both the borrower and the bank.

The borrower benefits because the takaful compensation helps reduce the financial burden of rebuilding the damaged property and allows the business to resume operations more quickly.

The financier benefits because the takaful protection helps preserve the value of the asset supporting the financing and reduces the risk that the outstanding financing will not be repaid because of a major loss.

Therefore, insurance and takaful play an important role in finance by protecting financed assets, supporting the recovery of borrowers after unexpected losses, and reducing the financial risks faced by lending institutions.