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:
mnsiddiqi@hotmail.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.
2- Ethics
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.