Evolution of Islamic Banking and
Insurance as Systems Rooted in Ethics*
Takaful Forum, New York, April 26, 2000
Mr. President, Brothers and Sisters
It is heartening indeed to see that the subject of insurance has at last started getting the attention it deserves. Your Forum and the presence of distinguished scholars as well as practitioners in the field of Islamic insurance and banking is reassuring. I have come to learn and refresh myself on the subject. But in compliance with the wishes of the organisers, especially my friend Omar Fisher, I venture to make some observations which could provide a perspective to the other presentations and deliberations.
1. Economic Progress
Man has needs which he seeks to fulfil in ways available. One such need is exchange as no one can survive, much less live efficiently, on what he himself can produce. In the beginning there ____________________
* Mohammad Nejatullah Siddiqi, Professor, Centre for Research in Islamic Economics, King Abdulaziz University, Jeddah, Saudi Arabia, email: email@example.com
was barter but it was problematic and inefficient. Soon some objects came to be used as means of payment. These could be carried over time, so we had ‘money’ serving as medium of exchange as well as store of value. Providing for future needs led man to invest in order to enlarge the scope of what could be done – that was money as ‘finance’. As trade developed within and between regions and communities the role of finance increased and financial intermediation became a possibility with new promises. Modern banking spread with the social acceptance of bank credit, fractional reserve and paper currency, enabling an increasing population to cope with larger and larger volumes of trade and investment in a fast expanding world.
With each new development new risks appeared. The farther into future man looked the more uncertainty he encountered. Handling risk and uncertainty became an increasingly prominent aspect of economic life even for ordinary men and women. Early ways and means of handling risks and uncertainty took simple forms of cooperation between the near and the dear. Pooling, sharing, diversification all occurred within the framework of trust, reciprocity and mutuality. That was insurance / takaful.
As uncertainties increased and risk became more complex shifting risks to those willing to take them (in expectation of gain, of course) and unbundling them into manageable parts took new forms. The earlier simple stratagem of insurance and coinsurance among people brought together by kinship or vocation or trade … yielded to more sophisticated arrangements open to wider groups of people. Sometime along this bumpy road man hit upon the Law of Large Numbers and the Law of Averages. This discovery reinforced a lesson learnt in antiquity: By coming together men could face risks and uncertainties they could hardly cope with individually. That I believe is the core idea behind insurance and takaful just as financial intermediation is the core idea behind banking. Both have had revolutionary impacts on economic progress, each in its own way.
Running parallel to the saga of economic progress is another thread, the ethical imperative of doing things in a manner that does not harm others or violate social interests. Even though morality is a human need in the sense that man’s felicity and ultimately his survival depends on ethical conduct, in reality ethical conduct does not always obtain. Men misbehave. They act in immoral ways, one harming other. Some violate public interest. Ultimately these end up harming themselves too. This necessitated reminders and warnings and a reaffirmation of ethical conduct. It also necessitated arrangements for information, its acquisition and dissemination as well as preventing its withholding where due. Prophets and saints, philosophers and statesmen, and many ordinary men and women of strong commonsense kept reminding and warning that economic activity must be informed by public purpose and a care for the interest of others along with serving the interests of the actor himself. They also emphasised truthfulness, the key to information.
Islam has legislated the minimum of morality necessary for human felicity, leaving for persuasion and voluntary compliance higher standards of morality which could make life better, more decent. Prohibition of riba (interest) and maysir (gambling) along with the strictures against telling lies, fraud and deception and breach of contract are the most relevant provisions of Shariah, insofar as economic activity is concerned. Given these, helping behaviour and regard for public interest could ensure good society so far as the economic aspect is concerned.
It is in this perspective that one should see how modern banking and insurance were handled by the Muslim peoples. When they came out from under colonial rule they scrutinised these arrangements in the light of Islamic laws and ethics. This was necessary as these artefacts had evolved into an alien ethos and planted in Muslim societies by rulers with little regard to the interests of these societies or their norms and values. Let us first see what the Muslim mind did to banking.
3. Islamic Banking
Beginning the middle of the twentieth century projects were launched to establish banking companies which would neither pay interest nor earn interest. Bank-depositor relation would be based on the depositor sharing the profit accruing as a result of the bank’s profitable use of the deposits pooled together. On the asset side a number of ways were tried to earn profits including partnerships and profit-sharing (mudaraba) with businessmen. Many Islamic banks entered into business directly, buying and selling commodities, land or real estate. Experimentation soon led to what is currently the predominant form of Islamic finance, i.e. murabaha. In this mode of finance the bank buys something on the specific request of a client and sells it to that client at a price higher than the purchase price, to be paid after a period of time. Leasing and prepaid orders (salam / istisna) were also used as profitable employment of the pool of deposits.
In a nutshell, the core idea behind commercial and investment banking, that of financial interemediation, was retained but the ethically repugnant practice of interest on loans was discarded. Within a short period of fifty years, the first half of which was devoted mainly to theory and model building, Islamic banking established itself as an alternative, claiming ethical superiority over conventional banking.
What is unethical about riba / interest to evoke such a response to interest-based banking from the Islamic civilization? The Quran (2:279) characterises it as unfair, as implied by the word zulm (oppression, exploitation, opposite of adl i.e. justice). Man’s environment does not guarantee positive return to productive use of money capital as value productivities lie in the future surrounded by uncertainty and risk. Some risk is involved in the productive use of money capital which, in fairness, the supplier of money capital must share if he wants a share in the profit of productive enterprise. A loan seeking positive return must share the risk involved in its use, otherwise it is to be returned without increase. As argued by Islamic economists this unfairness at the root of conventional banking is bound to affect its efficiency also as money capital would tend to be allocated on the basis of credit-worthiness of the borrowers rather than expected productivity of the projects being financed. They have also demonstrated how interest contributes to the instability of the capitalist system. All this refers to loans to business enterprises. When it comes to consumption loans the unfairness of interest and its negative impact on society become more obvious. Whether for business or for consumption, interest on loans violates the cooperative nature of man’s life requiring fairness and care for others.
4. Islamic Insurance
The story of Islamic insurance is no different. One issue was to avoid interest in the investment of the contributions / savings / premia deposited by those taking insurance. That was easily done as the establishment of Islamic banks preceded the establishment of Islamic insurance companies. As a matter of fact the first Islamic insurance company was established towards the end of 1978 at the behest of the Faisal Islamic Bank of Sudan. Now Islamic insurance companies have a whole range of Islamic financial instruments in which to invest.
The other ethical imperative was to prevent insurance from degenerating into gambling. Gambling inheres into games of chance played for a gain. The activity is created or voluntarily entered into. It is not like the chances one has to take in the ordinary business of life, i.e. the risks and uncertainties attending upon sale, purchase, investment and production, even upon travel, choosing a career or choosing your doctor. The unambiguous examples of gambling are bets in horse race, in games of cards or on spinning a roulette wheel. The financial risk involved in gambling could have been avoided if the gambler wanted to do so, by not playing the game. Not so in the case of risks in productive enterprise, investment or travelling, for to avoid financial risks in these cases one has to give up not a game but the ‘ordinary business of life’.
Like interest, gambling also violates the spirit of cooperation and fairness on which civilization is based. The appropriation of existing wealth already owned by some one by mere chance is unethical. Wealth is either appropriated directly from the (yet un- owned) pool of nature, or transferred to the new owner by the old owner as a gift, against a price or by inheritance. As the gains of the gambler do not belong to the first category we have to examine its legitimacy as a transfer from the old owner. The unethical nature of this transfer reveals itself if we look at the way the old owner must have come upon it. It is largely a product of work. As explained elsewhere ownership rights on the bases of work, inheritance or gift are ethically justifiable*. They have a rationale, serve a social purpose and do not violate fairness or the spirit of cooperation. Allowing wealth to be transferred by pure chance would make a mockery of that rationale and the social function of ownership. It would be unfair to transfer wealth acquired on the above mentioned grounds to one who does not qualify on any one of those grounds.
* Mohammad Nejatullah Siddiqi, Islam ka Nazariyah Milkiyat (Islam’s Theory of Property) Chapter II and III, Delhi, Markazi Makteba Islami, 1978.
Shah Wali Allah of Delhi (1703 – 1762) saw the above clearly. As Baljon noted:
“The requirement of mutual aid is, in the opinion of Shah Wali Allah, the main ground for the prohibition of maysir (gambling) and riba (interest)”1
One need read the whole passage2 to appreciate Wali Allah’s conclusion that “Both ways of gain (i.e. maysir and riba) are tantamount to inebriation, as they are in flagrant contradiction with the principles God has laid down for earning a livelihood”3.
5. The Core Idea behind Insurance
Modern insurance (Takaful) is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. ‘Insurance by combining the risks of many people enables each individual to ____________________
1. Baljon, J.M.S. Religion and Thought of Shah Wali Allah Dahlawi (1703-1762) 1986, Leiden, E.J. Brill, p. 192.
2. Para II on page 106 of Vol. 2 in Hujjat Allah al Baligha, Ist Cairo Edition, 1355 H.
3. Baljon, op cit. P. 192.
enjoy the advantage provided by the Law of Large Numbers.1’ Of course the numbers are not usually ‘large enough2’ so that actual values deviate from the expected values. The theory of risk seeks to analyse these deviations. Theories seldom reach perfection, yet practice fumbles on as life in the modern metropolis is hardly possible without insurance, especially in societies with shrinking nuclear families and neighbourhoods of diverse ethnic groups.
Insurance, however, is only one form of handling risk by pooling or unbundling and/or shifting it to those who are willing to take it in expectation of a gain. One other form is the market for common stock. As explained by Kenneth Arrow, ‘By this means, the owner of a business could divest himself of some of the risks, permitting others to share in the benefits and the losses. Since each individual could now own a diversified portfolio of common stocks, each with a different set of risks attached, he could derive the benefits of a reduced aggregate risk through pooling: thus, the stock market ____________________
1. Peter L. Bernstein, Against the Gods, The Remarkable story of Risk, John Wiley, 1996, p. 204.
2. Karl H. Broch, Economic of Insurance, North Holland, 1992, p. 112.
permits a reduction in the social amount of risk bearing1.” Arrow has also pointed out that ‘insurance is a very subtle kind of contract; it is an exchange of money now for money payable contingent on the occurrence of certain events’2.
It is this subtlety that has been causing problems for contemporary Islamic jurisprudence which failed to take a macro view of the matter. In order to avoid endorsing ‘contingent’ payments which obviously involve gharar, under pressure from the necessity of insurance, some have tried to model it on altruistic giving (tabarru`) or charity. But the notion of charity can hardly survive the explicit reciprocity involved in takaful. The gharar / uncertainty involved in the contract between one individual and the insurance company, because of the contingent nature of the payment, tends to disappear when large numbers are involved. What is still contingent for the ____________________
1. Kenneth J. Arrow, ‘Insurance, Risk and Resource Allocation’ in Foundations of Insurance Economics. Readings in Economics and Finance, edited by George Dionne and Scott E. Harrington, Kluwer Academic Publishers, Boston / Dordrecht / London, p. 221.
2. ibid, p. 120.
individual becomes routine for the group as a whole as well as for the company1.
6. Commercial Vs. Cooperative Insurance
Since the core idea on which mutual insurance or takaful is based is the same as behind all insurance, the distinction between mutual and commercial forms of insurance is a matter of organisation, not a matter of substance. When the give and take involve large number of people some coordination would be necessary. Such coordination has to be paid for. The manager may receive his salary from a mutual or a commercial, the activity remains the same. The choice between the two forms of organisation should be guided by considerations such as efficiency, transparency etc, in short, on maslaha, good of the people. The form of the organisation does not affect the legitimacy of the activity itself. It is not good reasoning to characterise mutual insurance as cooperation and commercial insurance as illegitimate profiteering. ____________________
1. For further elaboration see the author’s earlier work, Insurance in an Islamic Economy, Leicester, The Islamic Foundation, 1985.
As Ibn Khaldun remarked1, trade itself is a form of cooperation: “Man cannot survive as an individual in isolation, by his very nature he needs cooperation to get what he requires. This cooperation inevitably involves, first quid pro quo (mu`awada) then sharing (musharaka) and other forms”. In fact for - profit activities often prove to be better coordinated than those done in charity – the lesson so succinctly taught by Adam Smith2. That these same require regulation and overseeing by Social Authority is not to be denied.
Having said that, I have no intention to wish away the problems surrounding insurance. Regulators worked hard to purge insurance from elements of gambling in its early days. But the task is hardly complete as newer more subtle opportunities of speculation present themselves. Nor has the battle against fraud and deception ended. We have only to remember the breaking story of the Lloyd’s of _______________________
1. Ibn Khaldun, Muqaddima, Beirut, al Maktaba al Asariyah, 1996, p. 439.
2. Adam Smith. An Enquiry into the Nature and Causes of the Wealth of Nations, Vol. 1, p. 13, 1776 republished 1910.
London to convince ourselves to the contrary1. Then there is the perrenial issue of moral hazard; of insurance changing the behaviour of the insured in an undesirable way. There is no doubt a ‘dark side2’ to insurance. Neither the regulators nor the preachers can leave things as they are. Public intervention would always be called for to ensure fairness, elminate fraud and protect the consumer. Insurance is too important for modern living to be prohibited as a preventive measure (saddan liz zariah) No doubt it is vulnerable to fraud and deception, even gambling, but so are the activities in the share market, currency market, even in commodity markets. Rather, the correct approach would be for the social authority as well as consumer groups to exercise vigilance and introduce needed regulations.
1. Time magazine, February 21, 2000.
2. Stephen P.D.’ Arcy, ‘The Dark Side of Insurance’ in Insurance, Risk Management and Public Policy, edited by Sandra G. Gustavsun and Scott E. Harrington, Kluwer Academic Press, 1994.
7. The Future
Islamic insurance is there to stay, whatever the organisational setup and whatever the juristic rationale. The question before
forums like the present one is how to take it to Muslim homes and how to do this ethically i.e. carefully protecting the interests of the people concerned. As Islamic banks and Islamic funds proliferate, it should not be difficult for Islamic insurance institutions to tag on, entering into strategic alliance with these banks and funds. Also the ulama owe it to the community to endorse Islamic insurance as vehemently as they have endorsed Islamic banking so that the community can forge ahead with a clear conscience.
Having efficient banking and insurance would still leave the larger issues of social justice and equity in need of attention. It is time we start doing that. But that beginning can be made only once we have left the exhausting as well as mind boggling job of wrangling with the formal legitimacy of insurance and some other financial contracts behind us. Shall we expect this Forum to make it possible. I pray for this. Join me, and thank you.