Takaful - Scientific Premium Calculation and Information Asymmetry

This statement means that although conventional insurers calculate premiums using statistics, actuarial science, and probability, the use of these methods does not necessarily remove the Shari’ah concern relating to maysir.

• The insurer has access to large amounts of information, such as:
• Historical accident rates
• Claims statistics
• Mortality rates
• Average size of claims
• Risk profiles of customers
• Expected future losses
• An individual policyholder normally does not have the same level of information.
• This difference in knowledge is called information asymmetry.

Example

Suppose an insurer studies 100,000 drivers and discovers that:

• Expected average claims per driver = RM700
• Expected expenses per driver = RM200
• The insurer wants an additional margin for profit and unexpected losses.

The insurer may therefore charge:

Premium = RM1,200

The policyholder, Ahmad, only knows:

• He pays RM1,200.
• He does not know whether he will have an accident.
• He does not know whether he will ever make a claim.

But the insurer has statistical information showing that, across thousands of customers, it expects the premiums collected to exceed the expected claims and expenses.

Why does the statement say the insurer may “disproportionately profit”?

Because the insurer is in a stronger informational position.

For example:

10,000 policyholders × RM1,200 premium = RM12 million collected

Based on its statistical calculations, the insurer may expect:

• Claims = RM7 million
• Expenses = RM2 million
• Remaining expected amount = RM3 million

The insurer cannot predict which particular person will have an accident, but it can estimate quite accurately how many claims will occur across the whole group.

Therefore:

Individual policyholder → faces considerable uncertainty about his own outcome

while

Insurer → uses large-scale data to predict the overall outcome and price premiums accordingly

This is the information asymmetry referred to in the statement.

Connection to Maysir

The argument is that scientific calculation does not completely remove the underlying uncertainty:

Policyholder pays a certain premium

→ Individual claim remains uncertain

→ Insurer uses probability to price the uncertainty

→ Insurer seeks to earn a commercial profit from managing that uncertainty

So the text is essentially saying:

Actuarial science makes the insurer better at predicting and pricing uncertain events, but it does not make those events certain.

Important Point

This does not mean the insurer is guaranteed to make a profit.

A flood, earthquake, unusually high number of accidents, or other unexpected event could cause claims to exceed expectations and result in losses.

Rather, the argument is:

Scientific premium calculation increases the insurer’s probability of making a profit over a large portfolio because the insurer has superior statistical information and risk-pricing capability.

Easy Way to Remember

Information asymmetry = Insurer knows much more about the statistical risk than the individual policyholder.

Scientific pricing = Insurer uses that information to set premiums above its expected claims and costs.

Shari’ah concern in the passage = The insurer commercially profits from an uncertain event that the individual policyholder cannot predict as effectively.

Takaful - Maysir in Conventional Insurance

• Maysir refers to gambling or a gambling-like transaction in which financial gain or loss depends heavily on an uncertain event.
• Conventional insurance is said to contain an element of maysir because the policyholder pays a premium in return for the possibility of receiving compensation if the insured event occurs.
• If the insured event does not occur, the policyholder may receive no claim payment from the premiums paid.

1. Premiums Resemble a Bet on an Uncertain Event

• The policyholder pays a known amount as premium.
• Whether the policyholder receives compensation depends on whether an uncertain insured event occurs.
• This creates a situation where the financial outcome depends on chance or uncertainty.

Example

• Ahmad pays RM1,000 for motor insurance.
• Two possible outcomes may occur:

Outcome 1

• No accident occurs.
• Ahmad receives no claim payment.

Outcome 2

• A serious covered accident occurs.
• Ahmad may receive RM50,000 or more in compensation.

Simple Idea

Small known payment → uncertain possibility of a large payment → Maysir concern

2. Gain and Loss Depend on Whether the Event Occurs

• The policyholder’s financial result depends on whether the insured event happens.
• The insurer’s financial result also depends on the number and size of claims that occur.

Example

If Ahmad pays RM1,000:

• No accident occurs:
• Ahmad receives no claim.
• The insurer keeps the premium, subject to its expenses and obligations.
• Accident occurs:
• Ahmad may receive RM50,000.
• The insurer must pay substantially more than the premium received from Ahmad.
• The uncertain event therefore determines which party experiences the more favourable financial outcome.

3. Insurance Uses Probability, but the Uncertainty Still Exists

• Modern insurance is not operated simply by guessing.
• Insurance companies use:
• Statistics
• Historical claims data
• Actuarial calculations
• Probability models
• Risk classification
• These tools help the insurer estimate how frequently losses are likely to occur and how much premiums should be charged.

Example

• An insurer studies thousands of drivers.
• It determines that a certain category of drivers has a higher probability of accidents.
• It charges those drivers higher premiums.
• This allows the insurer to predict expected claims more accurately.

However:

• The insurer still does not know exactly which individual policyholder will suffer a loss.
• The timing and amount of individual claims remain uncertain.

Simple Idea

Probability reduces uncertainty for the insurer as a whole, but does not remove the uncertainty of individual insured events.

4. Stock Insurance Companies Seek Profit From Managing Risk

• A conventional stock insurance company is owned by shareholders.
• Shareholders expect the insurance company to generate profit.
• The insurer therefore prices premiums so that, across many policyholders, it expects:
• Premium income
• Investment income
• Other income

to exceed:

• Claims
• Operating expenses
• Other costs
• The insurer uses actuarial and statistical information to improve its ability to price risks profitably.

Example

Suppose an insurer covers 10,000 cars.

• Total premiums collected = RM20 million
• Expected claims = RM12 million
• Operating expenses = RM5 million
• Expected remaining amount = RM3 million

The insurer uses probability and historical data to increase the likelihood that total premiums will be sufficient to cover claims and expenses while still producing a profit.

5. Information Asymmetry

• The insurer may have more detailed information than individual policyholders about:
• Claims statistics
• Probability of losses
• Pricing models
• Expected claim costs
• Overall portfolio performance
• This difference in information is known as information asymmetry.
• By using actuarial data across a large pool of policyholders, the insurer may be better able to predict the overall financial outcome than an individual customer.

Simple Example

• Ahmad only knows his own driving experience.
• The insurance company may have data from hundreds of thousands of drivers.
• The insurer can therefore estimate the probability of claims much more accurately than Ahmad.
• This allows it to set premiums designed to protect its financial position and generate expected profit.

Relationship Between Maysir and Gharar

• Maysir is closely connected to gharar.
• Gharar refers to the uncertainty in the contractual exchange.
• Maysir refers to the gambling-like gain or loss that may result from that uncertainty.

Example

Ahmad pays RM1,000.

At the beginning:

• He does not know whether an accident will occur.
• He does not know whether he will receive compensation.

This is:

Gharar → uncertainty

Then:

• No accident → Ahmad receives no claim.
• Major accident → Ahmad may receive a very large claim.

This creates:

Maysir → financial outcome depends on the uncertain event

Simple Relationship

Gharar → Uncertain contractual outcome → May lead to Maysir

However:

Gharar ≠ Maysir

They are related but remain separate Shari’ah concepts.

Easy Way to Remember

Gharar

Question:

“What will I actually receive?”

• Focuses on uncertainty in the contract.

Maysir

Question:

“Will I gain or lose depending on whether this uncertain event happens?”

• Focuses on the gambling-like financial outcome.

Simple Formula

Premium paid + Uncertain insured event + Possibility of large gain or no claim = Maysir concern

Very Simple Example

RM1,000 premium

→ No accident → RM0 claim

or

→ Major accident → RM50,000 claim

The dependence of the financial outcome on an uncertain event is the basis of the maysir concern in conventional insurance.

Takaful - Gharar in Conventional Insurance

• Gharar refers to excessive uncertainty, ambiguity, or lack of clarity in a contract.
• Conventional insurance contracts may contain gharar because important elements of the transaction remain uncertain when the contract is entered into.
• This concern can arise in both:
• Life insurance
• General insurance

1. Uncertainty About the Insured Event

• At the time the insurance contract is made, neither party knows with certainty:
• Whether the insured event will occur
• When the insured event will occur
• How much the insurer may eventually have to pay
• The subject matter and financial outcome therefore remain uncertain until the insured event occurs.

Example

• Ahmad purchases motor insurance and begins paying premiums.
• An accident may happen:
• Immediately after his first premium payment, or
• Many years later, or
• It may never happen during the period of insurance.
• Therefore, Ahmad does not know at the beginning how much he will ultimately pay compared with how much compensation he may receive.

Simple Idea

Premium is known → Claim occurrence, timing and amount are uncertain → Gharar

2. Uncertainty About the Amount Paid by Each Party

• At the time the insurance contract is entered into, the total financial exchange between the parties is not known.
• The policyholder knows the agreed premium, but does not know:
• Whether a claim will occur
• How much compensation will be received
• The insurer also does not know:
• Whether it will have to pay a claim
• How large the claim will be

Example 1 – Accident Happens Early

• Ahmad pays his first premium of RM1,000.
• Shortly afterward, a serious covered accident occurs.
• The insurer pays RM100,000.

Therefore:

RM1,000 paid → RM100,000 received

Example 2 – No Accident Happens

• Ahmad pays premiums every year.
• No insured event occurs during the policy periods.
• Ahmad receives no claim payment.

Therefore:

Many premiums paid → No claim received

• The uncertainty between these possible outcomes creates the gharar concern.

3. Gharar in an Exchange Contract – ‘Aqd Mu‘awadah

• Conventional insurance is generally regarded as an exchange contract (‘aqd mu‘awadah).
• In an exchange contract, each party gives something in return for something else.

In conventional insurance:

Policyholder gives → Premium

Insurer gives → Promise of compensation if the uncertain insured event occurs

• Because the compensation depends on an uncertain future event, the amount and outcome of the exchange are not fully known.
• From the Shari’ah perspective described here, excessive gharar in a commercial exchange contract can affect the validity of the contract.

Simple Idea

Premium exchanged for uncertain compensation → Excessive gharar in an exchange contract

4. Gharar Through Lack of Transparency

• Gharar may also arise when there is insufficient clarity about how the policyholder’s premium is used.
• The policyholder may not clearly know:
• How much of the premium is used for management and administrative expenses
• How much is allocated to meet insurance claims
• How much is invested
• What investment returns are generated
• Whether the policyholder will receive any return or benefit from those investment results

Example

Suppose Ahmad pays an annual premium of RM5,000.

He may not know exactly:

• RM amount used for administration
• RM amount allocated for claims
• RM amount invested
• Investment return generated
• Whether any of that return benefits him
• This lack of clarity can contribute to the gharar concern.

How Gharar May Arise in Conventional Insurance

Uncertainty of Event

• It is unknown whether the insured event will happen.

Uncertainty of Timing

• It is unknown when the insured event may happen.

Uncertainty of Compensation

• The exact amount that the insurer may eventually pay is unknown.

Uncertainty of Financial Exchange

• The relationship between total premiums paid and compensation received is uncertain.

Lack of Transparency

• The policyholder may not clearly know how the premium is allocated and managed.

Easy Example

Ahmad buys insurance and pays RM1,000.

At that moment:

• He knows how much premium he paid.
• He does not know whether an accident will occur.
• He does not know when an accident may occur.
• He does not know whether he will receive compensation.
• He does not know exactly how much compensation he may receive.

Therefore:

Known premium + Uncertain insured event + Uncertain compensation = Gharar concern

Connection to Maysir

• Gharar and maysir are closely connected, although they are not the same.
• Gharar refers to the uncertainty in the contractual exchange.
• That uncertainty may create a maysir or gambling-like financial outcome.

Example

Ahmad pays RM1,000.

• No accident → receives no claim.
• Major accident shortly afterward → may receive RM100,000.

Therefore:

Gharar → Uncertain outcome → May contribute to Maysir

Easy Way to Remember

Gharar = Excessive uncertainty or lack of clarity

In conventional insurance, the uncertainty may involve:

Will the event happen?

When will it happen?

How much will be paid?

How much will each party ultimately give or receive?

How is the premium being used?

Simple Formula

Uncertain Event + Uncertain Timing + Uncertain Compensation + Lack of Transparency = Gharar Concern

Takaful - Riba in Conventional Insurance

• Riba is one of the main Shari’ah concerns associated with conventional insurance.
• According to the Shari’ah analysis presented here, riba may arise in conventional insurance in two main ways:
• Through the insurance contract itself
• Through the investment activities of the insurance company

1. Riba in the Insurance Contract

• The insured pays a certain amount of money in the form of premiums.
• In return, the insurer may later pay a monetary compensation.
• The amount eventually paid by the insurer may be:
• More than the premiums paid
• Less than the premiums paid
• Equal to the premiums paid
• In practice, exact equality between the two amounts is unlikely.

Example

• Ahmad pays total premiums of RM10,000.
• A covered event occurs.
• The insurer pays Ahmad RM100,000.

Therefore:

Ahmad pays RM10,000 → Later receives RM100,000

• Under this Shari’ah analysis, because money is exchanged for money in unequal amounts, the excess may raise an issue of riba al-fadl.

2. Riba al-Fadl – Riba of Surplus

• Riba al-fadl refers to an unlawful excess arising in the exchange of certain ribawi items, including money.
• In conventional insurance, the argument is that:
• The insured pays money as premiums.
• The insurer later pays a different amount of money.
• If the amount received exceeds the amount paid, there is an excess or surplus.

Example

• Premiums paid = RM10,000
• Compensation received = RM100,000
• Excess = RM90,000

Simple Idea

Money paid → Greater amount of money received → Riba al-Fadl concern

3. Riba al-Nasi’ah – Riba Due to Deferment

• Insurance payments also occur at different points in time.
• The insured pays premiums today.
• Compensation may only be received months or years later.
• Therefore, the exchange is not immediate.

Example

• Ahmad pays premiums over several years.
• Five years later, an insured event occurs.
• The insurer pays him compensation.

Under this analysis:

Money paid now → Different amount of money received later

• The deferment creates a concern of riba al-nasi’ah, or riba associated with delayed exchange.

Therefore, the same transaction may be argued to contain:

Unequal monetary exchange → Riba al-Fadl

and

Deferred monetary exchange → Riba al-Nasi’ah

4. Riba Through the Insurer’s Investments

• Riba may also arise from how conventional insurance companies invest their funds.
• Insurance companies collect premiums and invest part of these funds before claims are paid.
• Conventional insurers may invest in interest-bearing instruments, such as:
• Conventional bonds
• Interest-bearing deposits
• Other interest-based investments
• The investment returns generated from these activities may therefore contain riba.

Example

Premiums collected → Invested in conventional bonds → Interest earned → Riba

• The insurer’s profits may therefore include income derived from interest-based transactions.

What If Insurance Is Said to Be Based on Cooperation?

• Some may argue that insurance provides an important social function by:
• Helping people recover from losses
• Providing financial protection
• Promoting cooperation
• However, from the Shari’ah perspective discussed here, a beneficial purpose by itself does not remove the riba issue.
• If the contractual structure or investment activities involve prohibited interest, the Shari’ah concern remains.

Easy Way to Remember

Riba in Conventional Insurance Can Arise From Two Areas:

1. Insurance Contract

Premium paid

→ Money exchanged for a different amount

→ Payment occurs at a later time

→ Riba al-Fadl + Riba al-Nasi’ah concerns

2. Investment Activities

Premium funds

→ Invested in interest-bearing instruments

→ Interest income earned

→ Riba

Simple Summary

Riba in conventional insurance may arise from both the monetary structure of the insurance contract and the insurer’s interest-based investment activities.

Takaful - Prohibited Elements in the Stock Company Insurance Model

• The stock company model of conventional insurance is one of the most common insurance models in the market.
• From a Shari’ah perspective, this model may contain several prohibited elements.
• The three main prohibited elements are:
• Riba – interest
• Gharar – excessive uncertainty
• Maysir – gambling or gambling-like gain and loss

1. Riba – Interest

• Conventional insurance companies may invest premium funds and shareholder funds in interest-bearing investments.
• Examples include:
• Conventional bonds
• Interest-bearing deposits
• Other interest-based financial instruments
• The interest earned from these investments creates a riba issue.

Simple Example

Premiums collected → Invested in conventional bonds → Interest earned → Riba

2. Gharar – Excessive Uncertainty

• The conventional insurance contract contains uncertainty because the policyholder pays a known premium but does not know:
• Whether a claim will occur
• When a claim will occur
• How much compensation may eventually be received
• The insurer also does not know with certainty how much it will eventually have to pay.

Example

• Ahmad pays RM1,000 for insurance.
• He may receive:
• RM0 if no insured event occurs, or
• A large amount of compensation if a covered loss occurs.

Simple Idea

Premium is known → Claim is uncertain → Gharar

3. Maysir – Gambling-Like Outcome

• Maysir is closely connected to gharar in conventional insurance.
• The uncertainty in the insurance contract may result in a gambling-like financial outcome.
• The amount gained or lost depends on whether an uncertain event occurs.

Example

Ahmad pays RM1,000.

• If no accident occurs:
• Ahmad receives no claim payment.
• If a major accident occurs shortly afterward:
• Ahmad may receive RM100,000.
• Therefore, the financial outcome depends heavily on the occurrence of an uncertain event.

Simple Relationship

Gharar

→ Uncertainty about whether a claim will occur

→ Creates an uncertain financial outcome

→ May give rise to Maysir

Therefore:

Gharar ≠ Maysir

but

Gharar and Maysir are closely interconnected.

Why This Is Relevant to the Stock Insurance Company

• In a stock insurance company:
• Policyholders pay premiums.
• The insurer accepts the insured risks.
• The insurer undertakes to pay compensation if covered events occur.
• Shareholders own the insurance company and expect profits.
• The conventional structure can therefore involve:
• Gharar in the contractual exchange
• Maysir arising from the uncertain gain or loss
• Riba arising from interest-based investments

Easy Way to Remember

Riba → Problem with interest

Gharar → Problem with excessive uncertainty

Maysir → Problem with gambling-like gain or loss

Simple Formula

Conventional Stock Insurance Model → Riba + Gharar + Maysir → Shari’ah concerns

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Takaful - Why Conventional Insurance Is Not Shari’ah-Compliant

• Conventional insurance is generally based on a contract between the insurer and the insured/policyholder.
• The policyholder pays a premium to the insurer.
• In return, the insurer agrees to accept the insured risk.
• If the covered risk occurs, the insurer agrees to compensate or indemnify the policyholder according to the insurance contract.

Simple Process

Policyholder pays premium → Risk is transferred to insurer → Insurer accepts the risk → Covered loss occurs → Insurer pays compensation

Shari’ah Concerns with Conventional Insurance

• Most contemporary Islamic scholars consider conventional commercial insurance to be not Shari’ah-compliant.
• The main reason is that the conventional insurance contract may involve prohibited elements such as:
• Riba – interest
• Gharar – excessive uncertainty
• Maysir – gambling/speculation

Historical Shari’ah Rulings

• In 1965, the Congress of Islamic Research in Cairo was among the first official Islamic forums to discuss the permissibility of insurance.
• In 1976, the First International Conference on Islamic Economics in Makkah also considered the issue.
• In 1985, the International Islamic Fiqh Academy of the Organisation of Islamic Cooperation ruled that commercial insurance based on fixed periodic premiums is prohibited under Shari’ah.
• AAOIFI Shari’ah Standard No. 26 also states that conventional insurance is prohibited.
• In Malaysia, the Fatwa Committee of the National Religious Council ruled against conventional insurance in 1972.

1. Riba – Interest

• Riba refers to prohibited interest or unjustified increase in financial transactions.
• Conventional insurance companies may invest premium funds in interest-bearing investments.
• Examples include:
• Conventional bonds
• Interest-bearing deposits
• Other conventional fixed-income instruments
• Income earned from these investments may therefore involve riba.

Example

• Policyholders pay premiums into an insurance company.
• The insurer invests part of the premiums in conventional bonds.
• The bonds generate interest income.
• Because interest is prohibited under Shari’ah, this creates a riba issue.

Simple Idea

Premiums → Invested in interest-bearing assets → Interest earned → Riba

2. Gharar – Excessive Uncertainty

• Gharar refers to excessive uncertainty or ambiguity in a contract.
• In conventional insurance, at the time the policyholder pays the premium, neither party knows with certainty:
• Whether a claim will occur
• When the claim will occur
• How much the insurer may eventually pay
• The policyholder may pay premiums for many years and receive no financial benefit if the insured event never happens.
• Alternatively, the policyholder may pay only a small amount of premium and receive a very large claim payment shortly afterward.

Example

• Ahmad pays RM1,000 for insurance.
• There are two possible outcomes:
• No accident occurs → Ahmad receives no claim payment.
• A major accident occurs → insurer may pay RM100,000.
• At the beginning of the contract, neither party knows which outcome will occur.

Simple Idea

Premium is certain → Claim is uncertain → Amount and timing are uncertain → Gharar concern

3. Maysir – Gambling

• Maysir refers to gambling or obtaining gain based heavily on chance.
• Conventional insurance can resemble gambling because the financial outcome depends on whether an uncertain event occurs.
• One party may gain significantly while the other party suffers a financial loss.

Example

• Ahmad pays only RM1,000 in premium.
• Shortly afterward, a covered event occurs.
• The insurer pays Ahmad RM100,000.
• Ahmad receives much more than the amount he paid.

Alternatively:

• Ahmad pays premiums for many years.
• No insured event occurs.
• He receives no claim payment.
• The insurer retains the premiums, subject to the terms of the policy.
• This uncertainty of gain and loss creates the maysir concern identified by Islamic scholars.

Simple Idea

Small payment → Chance of large gain or no return → Gambling-like uncertainty

Stock Company Model and Shari’ah Issues

• The stock insurance company model is the most common form of conventional insurance.
• It is owned by shareholders.
• Policyholders pay premiums and transfer their risks to the insurer.
• The insurer accepts the risk and becomes responsible for paying covered claims.
• Shareholders ultimately seek to make profits from the insurance business.
• Shari’ah concerns may arise from:
• Risk-transfer structure
• Gharar in the insurance contract
• Maysir arising from uncertain financial outcomes
• Riba from prohibited investments

Simple Idea

Policyholder transfers risk → Insurer accepts risk for a price → Shareholders seek profit → Riba, Gharar and Maysir concerns may arise

What About Mutual Insurance?

• A conventional mutual insurer is different from a stock insurer because it is owned by its policyholders.
• This mutual structure is closer to the idea of collective risk-sharing.
• However, a conventional mutual insurer is not automatically Shari’ah-compliant.

Why?

• The mutual insurer may still:
• Invest funds in conventional bonds
• Earn interest
• Use other non-Shari’ah-compliant financial instruments
• Operate without Shari’ah supervision
• Therefore, even though the ownership structure is mutual, riba and other prohibited elements may still exist.

Simple Idea

Mutual ownership alone ≠ Shari’ah compliance

The investments, contracts and operations must also comply with Shari’ah.

Why Takaful Is Different

• Takaful was developed as a Shari’ah-compliant alternative to conventional insurance.
• Instead of simply transferring risk to an insurer, participants mutually share risks.
• Participants contribute to a common fund.
• Claims are paid from that participants’ risk fund.
• The Takaful operator manages the fund rather than acting as the conventional insurer that owns and accepts all the risk.
• Investments must be made in Shari’ah-compliant assets.

Simple Structure

Conventional Insurance:

Policyholder → Pays premium → Transfers risk to insurer

Takaful:

Participants → Contribute to common fund → Mutually share risks → Fund pays eligible claims

Easy Way to Remember

Conventional Insurance

• Risk transfer
• Premium paid to insurer
• Insurer accepts the insured risk
• May involve:
• Riba
• Gharar
• Maysir
• Investments may include non-Shari’ah-compliant assets

Takaful

• Risk sharing
• Participants contribute to a common fund
• Participants mutually assist one another
• Investments must be Shari’ah-compliant
• Structured to avoid:
• Riba
• Gharar
• Maysir

Simple Formula

Conventional Insurance → Risk Transfer + Possible Riba + Gharar + Maysir = Not Shari’ah-Compliant

Takaful → Mutual Risk Sharing + Shari’ah-Compliant Investments = Shari’ah-Compliant Alternative

Takaful - Meaning of an Insurance Contract

• Insurance is a contract between the insurer and the policyholder.
• The insurer accepts significant insurance risk from the policyholder.
• In return, the insurer agrees to provide compensation if a specified uncertain future event occurs.
• This uncertain future event is known as the insured event.
• The insured event must cause some form of loss, damage, or adverse financial effect to the policyholder.
• The insurer then provides compensation according to the terms and limits of the insurance contract.

Simple Idea

Policyholder faces a risk → Insurer accepts the risk → Insured event occurs → Policyholder suffers a loss → Insurer provides compensation

Takaful - What Constitutes an Insurance Contract?

An insurance contract is an agreement where the insurer accepts a significant insurance risk from the policyholder and agrees to provide compensation if a specified uncertain future event causes loss to the policyholder.

1. Payment of Premium

• The insured/policyholder pays a premium to the insurer.
• The premium is the amount paid in exchange for insurance protection.

Example

• Ahmad pays RM1,500 per year for motor insurance.
• In return, the insurer agrees to provide protection according to the policy terms.

Policyholder pays premium → Insurer provides insurance protection

2. Transfer of Risk to the Insurer

• The insurer agrees to accept the financial consequences of a specified uncertain future risk.
• The event may or may not happen.
• If the covered event occurs, the insurer becomes responsible for providing the agreed compensation.

Example

• Ahmad insures his car against accidental damage.
• Ahmad does not know whether an accident will happen.
• If a covered accident occurs, the insurer pays according to the policy.

Insured faces risk → Pays premium → Insurer accepts covered financial risk

3. The Event Must Be Uncertain and Beyond Both Parties’ Control

• The insured event must be uncertain.
• Neither the insurer nor the insured should deliberately control whether the event happens.
• Insurance is intended for accidental or uncertain events, not deliberately created losses.

Example

• A house may accidentally catch fire in the future.
• This is an uncertain event.
• However, if the owner deliberately burns down the house to claim insurance, this would not be a legitimate insured event.

Simple Idea

Accidental/uncertain event → Can be insured

Deliberately caused event → Generally not covered

4. Insurer Must Provide Compensation or Benefit When the Event Occurs

• If the covered event occurs, the insurer agrees to provide:
• Money
• Payment on behalf of the insured
• A service
• Another agreed benefit
• The insured normally does not need to pay another premium at the time of the claim, apart from any excess, deductible, or other amount required under the contract.

Example

• Ahmad’s insured car is damaged in an accident.
• Repair cost = RM15,000.
• The insurer may:
• Pay Ahmad
• Pay the workshop directly
• Arrange repairs on Ahmad’s behalf

Simple Process

Covered event occurs → Claim made → Insurer provides agreed benefit

5. The Contract Must Have a Specified Coverage Period

• An insurance contract must state when the protection begins and when it ends.
• The insurer is responsible only for covered events occurring during the specified period.

Example

Ahmad’s motor insurance runs from:

1 January 2026 → 31 December 2026

• Accident on 15 June 2026 → falls within the coverage period.
• Accident on 10 January 2027 → normally not covered because the policy has expired, unless renewed.

Simple Idea

Insurance protection only applies during the agreed contract period.

6. The Insured Must Have an Insurable Interest

• There must be a genuine relationship between:
• The insured person, and
• The person or property being insured.
• The insured must suffer a real financial or other recognised loss if the insured event occurs.
• This relationship is called insurable interest.

Example: Car Insurance

• Ahmad owns a car.
• If the car is destroyed, Ahmad suffers a financial loss.
• Therefore, Ahmad has an insurable interest in his car.

Example: House Insurance

• Sarah owns a house.
• If the house burns down, Sarah suffers a financial loss.
• Therefore, Sarah has an insurable interest in the house.

Why Is Insurable Interest Important?

• It prevents insurance from becoming a form of gambling or speculation.
• A person should not normally insure something where they would suffer no genuine loss if the event occurred.

Historical Example

• In the early development of life insurance, people could sometimes insure the life of someone with whom they had no genuine relationship.
• They could receive money if that person died.
• This created a situation similar to gambling on another person’s life.
• Insurable-interest rules developed partly to prevent such arrangements.

Easy Way to Remember the Six Features

1. Premium

• Insured pays the insurer

2. Risk Transfer

• Insurer accepts the covered financial risk

3. Uncertain Event

• The event must be uncertain and outside deliberate control

4. Compensation

• Insurer pays or provides a benefit when the covered event occurs

5. Coverage Period

• Insurance only operates during the agreed period

6. Insurable Interest

• The insured must genuinely suffer a loss if the insured event occurs

Simple Formula

Premium + Uncertain Risk + Risk Transfer + Compensation + Coverage Period + Insurable Interest = Insurance Contract

Takaful - Insurance Models There are two main corporate models used to provide insurance services: 1. Mutual Insurer A mutual insurer is owned collectively by its policyholders. The policyholders are both: Customers / insured persons Owners of the insurance entity Each policyholder places their individual risk into a common pool. The risks of all policyholders are pooled together. As owners, the policyholders collectively bear the pooled risks. Any remaining financial interest or surplus ultimately belongs to the policyholders. Simple Example 1,000 people join a mutual insurance company. Each person pays a premium into the common pool. If some members suffer insured losses, claims are paid from that pool. Because the policyholders collectively own the insurer, they ultimately share in the financial results of the organisation. Simple Idea Policyholders = Insured persons + Owners

2. Stock Insurance Company A stock insurance company is owned by shareholders or investors. The people who buy insurance are normally customers, not owners of the company. Shareholders provide capital to support the insurance business. The insurer collects premiums from policyholders and accepts the risks covered under the insurance contracts. Claims are paid when covered insured events occur. Shareholders are entitled to the profits generated by the insurance company. Insurance Fund In some countries, regulators require the insurer to maintain an insurance fund separately from the shareholders’ fund. The insurance fund may therefore be legally or financially separated from the shareholders’ fund. However, the insurance company itself is still ultimately owned by the shareholders. Simple Idea Policyholders = Customers Shareholders = Owners

Why Stock Insurance Companies Developed Mutual insurers played an important role in the early development of modern insurance. Over time, investors recognised that insurance could also become a profitable commercial activity. Insurance businesses therefore increasingly developed into stock companies financed by shareholder capital. Another important reason was the increasing size of potential insured losses. As economies and businesses grew, insurers had to be able to cover increasingly large claims. Modern insurance companies therefore require substantial capital to strengthen their ability to meet these obligations.

Role of Shareholder Capital Shareholders contribute money known as shareholder capital to the insurance company. This capital exists in addition to the premiums collected from policyholders. It provides additional financial strength to the insurer. Shareholder capital can be used to: Support the establishment of the insurance company Finance operating activities Meet regulatory capital requirements Maintain liquidity Invest in permitted assets Absorb unexpected losses Provide an additional financial cushion if claims are higher than expected Shareholder capital therefore increases the probability that the insurance company will be able to pay valid claims. Simple Relationship Premiums + Shareholder Capital → Greater Financial Capacity to Pay Claims Example Shareholders invest RM50 million in an insurance company. Policyholders later pay RM100 million in premiums. The insurer now has financial resources from: Shareholder capital Premium income The RM50 million shareholder capital does not necessarily remain unused. Part may be: Invested Kept in cash or liquid assets Used to support operations Held as financial capital to absorb unexpected losses

Underwriting Process Before providing insurance coverage, the insurer carries out underwriting. Underwriting is the process of evaluating the risk before accepting it. During Underwriting, the Insurer: Examines the risk Estimates the probability that a loss may occur Estimates the possible size of the loss Decides whether to accept the risk Determines the appropriate premium Determines the terms and conditions of the insurance coverage Example Ahmad wants to insure his car. Before providing coverage, the insurer evaluates factors such as: Type of car Value of the car Age of the vehicle Ahmad’s driving history Probability of an accident Expected cost of possible claims Based on these factors, the insurer determines the premium Ahmad must pay. Simple Process Insurer evaluates risk → Sets premium → Accepts risk → Provides coverage → Pays claim if a covered event occurs

How a Stock Insurance Company Makes Profit Shareholders invest their capital because they expect to earn a return on their investment. An insurance company can generate profit from several different sources. These include: Underwriting surplus Expense profit Investment margin

1. Underwriting Surplus Policyholders pay premiums to obtain insurance coverage. The insurer pools these premiums. Claims are paid when covered insured events occur. If the premium income available is greater than the claims and related insurance costs, an underwriting surplus may arise. Simple Relationship Premium Income > Claims and Related Costs → Underwriting Surplus Example Suppose: Premium income = RM100 million Claims and related costs = RM80 million Therefore: RM100m − RM80m = RM20m underwriting surplus This surplus contributes to the overall financial result of the stock insurance company. Because shareholders own the company, they ultimately benefit from the company’s profits, subject to reserves, regulatory requirements, taxes, retained earnings and dividend decisions.

2. Expense Profit Part of the premium charged to policyholders is calculated to cover the insurer’s expected operating expenses. These may include: Employee salaries Administrative costs Office costs Technology systems Distribution costs Other operating expenses If the insurer’s actual expenses are lower than the amount allowed for expenses in the premiums, an expense profit may arise. Example Amount provided for expected expenses = RM10 million Actual expenses = RM8 million Therefore: RM10m − RM8m = RM2m expense profit

3. Investment Margin Insurance premiums are generally received before claims are paid. Therefore, premium funds do not necessarily remain static while the insurer waits for claims. Part of the premium funds may be invested while they are not immediately needed. The insurer must still keep sufficient funds available to: Pay claims Cover operating expenses Maintain reserves Maintain liquidity Meet regulatory requirements Example The insurer receives premiums today. Some claims may only arise several months or years later. During this period, the insurer may invest part of the available premium funds. The investments may generate a return. This return contributes to the insurer’s financial results. Simple Relationship Premiums Received → Part Kept Available + Part Invested → Investment Income Earned

Can Premiums Be Invested? Yes, premium funds can also be invested. Premiums do not simply sit untouched until a claim occurs. The insurer usually receives premiums before claims need to be paid. This creates an opportunity to invest part of the available funds. Example Suppose an insurer collects RM100 million in premiums. The insurer may manage the money approximately as follows: RM25 million Kept as cash or highly liquid assets Available to pay near-term claims RM60 million Invested in permitted assets Generates investment income RM15 million Used for operating expenses and other obligations Therefore: Premium Received → Part Kept Available → Part Invested → Claims and Expenses Paid as Required

Can Shareholder Capital Also Be Invested? Yes, part of the shareholder capital may also be invested. However, shareholder capital does not have to be invested entirely. It supports the overall insurance business. Example Suppose shareholders provide RM50 million. The insurer may use it approximately as follows: RM30 million Invested in permitted assets RM10 million Kept as cash or liquid assets RM5 million Used for initial operating or setup costs RM5 million Retained as part of the company’s financial cushion Therefore: Shareholder Capital → Operations + Liquidity + Investments + Financial Cushion It should not be understood as: Shareholder Capital → Investment Only

Two Main Sources of Funds in a Stock Insurance Company Shareholder Capital Comes from the shareholders or owners. Represents their investment in the insurance company. Supports the establishment and operation of the company. Provides additional financial backing. Helps absorb unexpected losses. May be invested. Helps the company meet capital and regulatory requirements. Policyholder Premiums Come from customers purchasing insurance coverage. Mainly support: Claims Insurance expenses Reserves Other insurance obligations Part of the premiums may also be invested until needed. Important Difference Shareholder Capital Comes from owners Provides financial backing to the company Can absorb losses May generate investment income Premiums Come from policyholders Are paid in exchange for insurance protection Mainly support claims and related expenses May also generate investment income while waiting to be used

Combined Example Suppose: Shareholders invest = RM50 million Policyholders pay premiums = RM100 million The insurer may decide: RM30 million of shareholder capital is invested RM60 million of premium funds is invested Therefore: RM30m + RM60m = RM90m invested Suppose the investments produce a return of RM4 million. The RM4 million becomes part of the insurer’s investment income. This investment income contributes to the company’s overall financial performance. Therefore, investment income can arise from: Invested Shareholder Funds + Invested Premium Funds

Easy Comparison Mutual Insurer Owned by policyholders. Policyholders are both: Customers Owners Policyholders collectively participate in the mutual insurance arrangement. Risks are pooled among the members. The residual financial interest ultimately belongs to the policyholder-members. Any surplus ultimately benefits the policyholder-members. There are no outside shareholders expecting a return on shareholder capital. The main focus is mutual protection. Simple Idea Policyholders insure together and own the company together.

Stock Insurance Company Owned by shareholders. Policyholders are mainly customers. Shareholders provide capital to support the insurer. The insurer accepts and manages the policyholders’ insured risks. The residual financial interest belongs to the shareholders. Profits ultimately benefit shareholders. Shareholders expect a return on the capital they have invested. The company operates on a commercial basis. Simple Idea Customers buy insurance, while shareholders own the company and expect profits.

Easy Way to Remember Mutual Insurance Policyholders = Customers + Owners They pay premiums. Their risks are pooled. They collectively own the mutual insurer. Surplus ultimately benefits them. Stock Insurance Policyholders = Customers Shareholders = Owners Policyholders pay premiums for protection. Shareholders provide capital to support the company. Both premium funds and shareholder funds may be invested. Shareholders ultimately benefit from the company’s profits.