The Conventional Insurance System V Takaful Insurance System
Transcript of The Conventional Insurance System V Takaful Insurance System
1Conventional and Islamic Insurance Systems
The Conventional Insurance System versus the Islamic Insurance System
Conventional Insurance System
Most of people have fear and they do not like risk. Happiness is the main
object to the humanity. Making money is an important condition to get happiness and
by investing the money, people can make more money to satisfy their needs. Investing
money involves risk, which increase the return on this money. Generally, investors
prefer to increase the return and decrease the risk. Chinese and Babylonian traders in
the 3rd and 2nd millennium BC practiced one of the earliest methods of transferring or
distributing the risk. Chinese merchants preferred to move their goods by shipping
them on several boats to diversify the risk. Persia was the first country that attempted
to insure its people and made it official by registering the insuring process in
governmental notary offices. The Jewish rabbis claim that The Talmud deals with
several aspects of insuring goods. The Greeks and Romans introduced the origins of
health and life insurance c. 600 AD. In the 14 thcentury, Italian merchants insured their
exports and imports, which were moved from or to Genoa coast. In the late 17th
century, Edward Lloyd opened a coffee house that became a popular meeting place
for the ship owners, merchants, and ships’ captains. Edward Lloyd 's coffee house
became the meeting place for parties wishing to insure cargoes and ships. Because of
the great fire of London in 1680, Nicholas Barbon established England's first fire
insurance company (Dorfman, 2007). The first insurance company in the United
States was established by Benjamin Franklin in 1732, he helped to popularize and
make standard the practice of insurance. In the 17th and 18th centuries, many
companies in London (The center of world trade in 17 century) and U.S.A started to
establish the rules and laws that standardized and formulated the conventional
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The insurance company represents the 1st party of the insurance contract and
has a name of the insurer. The 2nd party of the contract represents the customer of the
insurance company and has a description of insured or a name of the policyholder or
policy owner. The insurance contract forces the insurer to protect the policyholder
from the risk of losses and compensate him for these losses. The policyholder should
pay the fees of the insurance policy or the premium to the insurer to get the right of
the compensation of the losses (Dorfman, 2007).
The process of the conventional insurance system is very simple and clear.
The insurance process begins when the policyholder pay the premium to the insurer.
The insurance policy represents the insurance contract and it has a maturity or expiry
date. The policy protects the policyholder from risk of the loss causes by the damage
of the insured property or person. The insurer or the insurance company receives the
premiums from the policyholders and invest them in profitable projects to generate
returns to the insurer. The greatest amounts of the returns go as an income to the
owners of the insurance company, which can be the stockholders of the insurance
company. The rest of the returns go as operating expenses to the insurance company
to complete the insurance arrangements, the policyholders do not have any right in
these returns. The insurer has to compensate the policyholder against any peril, that
causes the loss of the insured property or person during the maturity date of the
insurance policy. Each insurance policy has to identify clearly the types of the perils
that cause the losses to the policyholder. In addition, the amount and the value of the
compensation that is right to the policyholder should be clearly identified in the
insurance policy. The policyholder could trick and make tricky accidents that cause
the losses of the insured property and get the amount of the compensation from the
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insurer. This action will repeal the insurance contract, gives the insurer the right of the
premium, and exempt him from the compensation's commitment.
The relationship between the risk and return is an inverse relationship, the
higher the risk the higher the return and vice versa. The insurance as a business is very
risky investment, which requires a very qualified and skilled staff to run the business.
In general, most of the insurance companies make huge amount of profits by
managing the risk of loss (Bodie, Kane, and Marcus, 2007). Most of the insurance
businesses follow the basic four insurance principles to limit the risk of loss. The first
principle is the similarity of a large group of items exposed to the same peril, which
allows the insurance companies to benefit from the law of the large numbers. This
means, as the number of similar items exposed to the same peril increase, the actual
results become more closely to the expected results. The second principle is the
definite and accidental loss, which allows the insurers to identify the time, place, and
location of the peril that result in the loss and just to cover the loss that is out of
control of the beneficiary. The third principle is the calculable loss and affordable
premiums, which allows the insurers to calculate the probability and the value of the
loss and determines the value of the premium according to size of the loss. The fourth
principle is to limit the risk that cause catastrophic losses, which means that t insurers
avoid to issue insurance policy to the events that requires huge compensations like
earthquake policies, hurricanes policies and wind policies (Bodie, Kane, and Marcus,
Insurance classification is very difficult and confusing. Most authors,
professors and the scientists face the problem of the insurance classification. In
general, insurance can be classified in different methods. Types of the Insurance
according to the insurer can be classified into two types. Public insurance that aims to
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help the citizens and support the country. Private insurance that aims to make profits.
Types of the insurance according to the insurance policies and the risks and perils
they cover can be classified to many and unlimited kinds. Insurance policies and
programs that are issued by and supported by the government are four types. The
social insurance policy covers the perils of retirement, disability, unemployment,
illness, and sickness. The agricultural insurance policy covers the perils that threaten
or destroy the agricultural crops. The industrial insurance policy covers the perils that
threaten the national plants and factories. The banking insurance policy covers the
financial perils that threaten the banking industry. Insurance policies and programs
that are issued the private insurance companies are uncountable and unlimited. Private
insurance policies can be classified into several categories; In general, they can be
classified to seven or eight types. Fire insurance policies cover the losses of the real
estate properties and human lives that are caused by the fires. Marine insurance
policies cover the losses of the mobile property; these policies secure the properties
that are moved by ships, trains, planes, and trucks. Causality insurance policies insure
against the accidents that injure the policyholder, this type can be classified to
different categories (Dorfman, 2007). Automobile insurance policies insure against the
car accidents that injure the policyholder and they include financial perils, medical
perils, and liability perils. Health insurance policies insure against the perils that
injure policyholder's health and they cover the policyholder medical costs (Dorfman,
2007). Crime insurance policies insure against the perils that are caused by criminals
or thieves. Disability insurance policies insure against the perils that affect the worker
ability to work to generate an income like accidents of labors and firing perils, these
policies compensate the worker until he can work and generate income again. Credit
insurance policies insure against the perils that affect the borrower ability to pay the
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loan payments to the lender. Legal liability insurance policies insure against the perils
that result legal commitments against the policyholder. Life insurance policies insure
against the perils that injure the life of the policyholder like death. Terrorism
insurance policies are the newest kind of the insurance policies and they insure against
the perils and losses which results from terrorist actions.
Terrorism Insurance Policies
Life Insurance Policies
Legal Liability Insurance Policies
Credit Insurance Policies
Disability insurance policies
Crime Insurance Policies
Health Insurance Policies
Automobile Insurance Policies
Causality Insurance Policies
Marine insurance policies
Fire Insurance Policies
Banking Insurance Policy
Industrial Insurance Policies
Agricultural Insurance Policies
Social Insurance Policies
Private Insurance Policies & CompaniesGovernment Insurance policies & Companies
Types of the Insurance Companies and Policies
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Standard line or life insurance companies and excess line or nonlife insurance
companies are the main two types of the insurance companies. Life insurance
companies issue life insurance policies, annuity insurance policies and pension
insurance policies. It is very difficult and complicated to manage life insurance
companies because they have long-term commitments and their works are very risky.
Nonlife insurance companies issue different types of policies like property insurance
policies, causality insurance policies and the rest types of the private insurance
policies. Managing this kind of insurance companies is easier than to manage the life
insurance policies because they have short-term commitments and their works is not
risky like life insurance companies. Credibility and reputation are the most important
two elements for the insurance companies because without these two elements the
insurance companies cannot attract the customers to buy the insurance policies. The
legislation in the insurance field is difficult and insufficient. Many laws and legal acts
were issued by financial authorities to regulate and standardize the insurance industry.
Many insurance companies do not respect their commitments to the policyholders and
most of them do not continue in their works. The U.S.A and U.K have the most
creditable insurance companies in the world. American Insurance Group is the biggest
insurance company in the world, which had a total value of assets about $1 trillion in
2007. Today, the global insurance industry grew by 12.3% and had a total value of
assets $ 4.1 trillion. The insurance industry is more developed in the developing
countries than in the developed countries (Bodie, Kane, and Marcus, 2007).
Insurance is useful for the economy and it has many benefits. One of the
greatest benefits which an insurance system rewards society is stability in families.
Insurance prevents from experiencing the great hardships caused by unexpected losses
of property or the premature death of the main income provider. Insurance is also very
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useful to businesses. Insurance aids planning process because the planner knows will
not mean financial ruin, and the future of the business cannot destroy by a fire or the
death of a key person. Insurance aids credit transactions. Lenders are more willing to
make property or real estate loans if they know a disaster cannot destroy the financial
security behind their loan. Insurance is also useful for the economy because it
functions as an antimonopoly device. If no insurance system was available, only the
largest businesses could sustain losses and remain in operation. In general, all
financiers recognize that insurance availability tends to lower a firms cost of capital
because both creditors and investors would charge much more for the use of their
money if it subjected to the risks associated with natural disasters in addition to
normal business risks (Dorfman, 2007).
Islamic Takaful Insurance System
Takaful insurance system or Islamic insurance system is the newest insurance
system in the world. It is difficult to talk about Takaful insurance because it is a new
and incomplete or imperfect insurance system. This insurance system has a short
history, not like the conventional insurance system. The Takaful industry is roughly
30 years young. Islam is an old religion that has a long history but no one during this
history discussed the permissibility or prohibition of the insurance because no Islamic
country adopted the insurance or dealt with the insurance officially (Kwon, 2007). Ibn
Abdin (1784-1836) was the first scholar in the Muslim World to discuss the meaning
and legal character of Insurance. Islamicity of insurance has been under discussion
since then. Mohammed Abduh was the first Islamic scholar during the decade that
started to formulate a new Islamic insurance system. In 1965, a group of Islamic
scholars of different mazahib (Islamic schools of thought) met and discussed the
reasons behind the prohibition or forbiddance of the insurance in Islam. In 1972,
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meeting of the Islamic Studies Conference (ISC) considered eighty opinions on
insurance submitted by scholars worldwide, but adjourned without making final
recommendations, leaving the topic pending for further study. The first Takaful
company was established in 1979 and it was the Islamic Insurance Company of Sudan
(Kwon, 2007). Today, there are some 28 registered Takaful companies worldwide and
there are 10 more insurance companies' have adopted Takaful programs. Many
countries have adopted the Takaful insurance system like Malaysia, Bahrain, Kuwait,
the U.A.E, Egypt, Saudi Arabia, Pakistan, Australia and Lebanon, the U.K, the U.S.A,
Philippines, Sri Lanka and Singapore. Malaysia is the best country in the Takaful
insurance industry and it has a rate of growth 60% annually (Jones, 2008).
Islamic or Takaful insurance system was adopted as an alternative to the
conventional insurance system. All the Muslims around the world receive the fatwa
from the certified Islamic scholars. Islamic scholars have four sources for the
legislation in Islam. They are the Quran (Islamic holy book), Sunman or Hadith sharif
(Prophet Mohammed's instructions), Ijma'a (consensus of legal Islamic scholars and
Qeyas (justice reasoning in Islam). Sheikh Mustafa Zarqa and many of the legal
Islamic scholars agree that conventional insurance is prohibited in Islam because of
four reasons. These reasons are Al Riba (excess or interest on loans), Al Maisir
(wagering, speculation, gambling) , Al Gharar (uncertainty, deception and unclear
terms) and Investment of premiums by insurers into non-Shariah compliant securities
. Insurance is blamed for Gharar because, at the time of the contract, the insured are
uncertain about occurrence of indemnity, amount occurred in case of indemnity, and
the timing of indemnity. However, supporters of insurance argue that these matters
are unknown only at the individual level, while at collective level, they are
scientifically determined by statistical laws of large numbers, actuary, and probability.
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Insurance is blamed for Maisir because the policyholders are seen to bet premiums on
the condition that insurer will make compensation payments (indemnity) of the
happening of specific event. The advocates of insurance argue that insurance is the
contract of indemnity, which is altogether different from gambling. A specific event
must occur by the appointed time and one of the parties must win or lose in gambling.
In the case of insurance, the specified event may or may not happen during the policy
period. Riba refer transaction involving unequal exchange of the same thing.
Insurance is viewed as un equal exchange of money in premiums and compensations.
In fact, money paid in premiums do not equal the money received in compensation.
The insured or the policyholder receives less or nothing when the policyholder
withdraws the policy, defaults on premium, does not experience peril, the insurance
contract is declared void due to any other reason. Compensation received from
insurers may be is greater than the premiums if a peril occurred. Here we have a riba
because the insured receives compensation that is higher than his premium. While in
the other side, when there is no happening of perils, the insured does not receive any
compensation, which results a profit for the insurer. The advocates of the insurance
argue that there is no riba in insurance because of several reasons. The money
received in claim by the insured (compensation) depends on the extent of financial
loss incurred in consequence of a peril. Individuals engage in riba transactions with
the sole purpose of monetary gains, while the purpose of the insurance policy is to
protect, not to enhance the financial position of the insured. Insurance is also essential
part of banking and international trade transactions. Insurance is illegal because the
compensation is given to nominees, which is contrary to the Islamic laws of
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Takaful insurance system is based on three principles. Mutual responsibility,
which means the feeling of responsibility towards one another. Mutual Co-operation,
which has the same meaning of this Hadith (Prophet Rule) "The relationship between
one believer and another (in a community) is like that of a building where one part of
the building strengthens the other parts." (Mutafaq 'alaihi). Mutual cooperation for the
protection of members in the event of loss.
There are five crucial elements that are very important and required to
formulate Takaful insurance. Ne'aa (intention) or utmost sincerity of Intention for
knowingly following the guidance and adhering to the rule and purposes of Takaful -
cooperative risk sharing and mutual assistance. Integration of Sharia conditions,
namely risk sharing under Ta'awuni (collaboration and cooperation) principles,
coincidence of ownership, participation in management by policyholders, avoidance
of Riba and prohibited investments, and inclusion of al Mudharaba. Presence of Moral
Value and Ethics. No Unlawful (illegal action or item) Element that contravenes
Sharia (Islam rules). Appointment of Sharia Advisory Council or Committee to
oversee the development and Islamic auditing of the Takaful operations.
Takaful is an alternative form of insurance. Consequently, many of the
principles and practices of insurance equally apply to Takaful. General Takafuls are
short-term contract for protection of potential material losses resulting from specified
catastrophes. Participants' installments are called tabaru (donation). Amount of
Takaful contributions varies, as in insurance, according to the value of property to be
covered under the general Takaful scheme. Company invests the tabaru funds, and the
profits accrued there from are allocated between the fund and the management on the
basis of mudaraba. Indemnity is paid out of the tabaru fund. Operational costs
including reinsurance costs and other reserves are also deducted from tabaru fund. If
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the fund generates net surplus then, unlike insurance, surplus is shared between
participants and the company. In sum, in case of general insurance, there is no
substantive difference between tabaru and the premium from the insured point of view
as the entire contributions of the participants are treated tabaru, like premium in
insurance (Dirrheimer & Sohail, 2008). The contribution, like premium, depends on
the value of the property to be
covered. However, unlike insurance, Takaful participants are entitled to surplus in the
tabaru fund, if any. Islamic life insurance is organized in the name of family Takaful.
Premiums, unlike insurance, are determined by the participants themselves depending
on their financial strength. Installments paid by the participants are divided into
Takaful, also called tabaru. The proportion for tabaru fund, like insurance, is
calculated on actuarial basis, which varies according to the age and participation
period of the participants. Insurance benefits are paid from the tabaru fund.
Participants pledge to make additional contributions if Takaful fund proves
insufficient. However, in reality, companies prefer to carry such deficits forward till
the Takaful fund enjoys surplus. In the meanwhile, companies finance the deficits on
the basis of interest free loans. The actual operating expenses are charged from the
Mudarabah accounts. Participants are entitled to reimbursements upon maturity,
withdrawal and, in some cases, upon disablement. Upon the death of a participant, his
profit shares are entitled to Takaful benefits. The Takaful benefits are reimbursed
according to the Islamic inheritance. If a participant withdraws before the maturity of
contract then money in the investment account is paid as surrender benefits. In the
case of the death of a participant, his heirs are entitled to full value of the decreased
participant's share in mudarabah investment account plus money equal to all unpaid
installments, due to be paid in future if he lived, from the Takaful account.
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Participants cannot interfere with management activities as the management assumes
full authority. However, if a loss occurs due to disrespect of modarabah conditions,
the Takaful companies will bear those losses.
Takaful operations in the insurance primary markets can be broadly classified
into one of the three models: a mudarabah model, a wakala model, and a hybrid
model. With the mudarabah model, both the policyholder and the insurer share profits
from Takaful operations. With the wakala model, there is a complete separation
between the insurer's capital and the policyholder's fund and the insurer receives a
fixed fee for managing/investing the fund on the policyholders' behalf; that is, all
profits from Takaful operations less fixed fees for underwriting and investment
services belong exclusively to policyholders. Under the hybrid plan, the insurer may
use a mudarabah model for underwriting activates and a wakala model for investment
activities. It is worth a little that operating losses are born only by policyholders in all
three models. In all Takaful models, insurers use their capital (shareholders' fund) to
provide interest-free loans to cover deficiency in the policyholders' fund. Reasonably,
all net gains and losses from investing the insurer's capital are of the insurer's own.
On the other hand, some Malaysian professors argue against the previous
classification and they suggest another model of Takaful classification (Kwon, 2007).
This Malaysian classification provides three types of Takaful insurance models. Non-
Profit Model includes social-governmental owned enterprises and programs operated
on a non-profit basis. Al Mudharaba Model, whereby cooperative risk sharing occurs
among Participants yet the Takaful Operator shares also in any operating surplus as a
reward for its careful underwriting on behalf of Participants. Al Wakala Model,
whereby cooperative risk-sharing occurs among participants with a Takaful Operator
earns a fee for services (as a Wakeel or Agent) and does not participate or a share in
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any underwriting results as these belong to Participants as Surplus or Deficit, operator
also charge a funds management fee (Dirrheimer & Sohail, 2008).
Takaful insurance system is one of the most dynamic areas of the boarder
market for Islamic financial services. As Moody's noted in a recent report, Takaful
has shown very impressive premium growth rates of about 20% in recent years. Total
Takaful has exceeded 2$ billion in 2005, and are expected to reach $7.5 billion by
2015. The famous economist, Fitch, puts the total global Takaful contributions at
about $2.6 billion (Jones, 2008). The Takaful insurance share in the insurance markets
is vey small compared with the world's insurance sector as a whole. But the Takaful
insurance industry will extend beyond its current size and there is substantial potential
for growth both in Muslim communities in the Middle East and Asia as well as in
some more mature markets (e.g., in France, Germany, UK, U.S.A, Canada, Spain,
Russia,….etc), which have significant Muslim minorities and significant desired
customers (Ashton, 2008).
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Note. The data on Takaful Potential Distribution are adopted from " Islamic Principle and Takaful
Insurance: Re-evaluation" by W. J. Kwon, 2007, Journal of Insurance Regulation, 26, pp. 53-81.
Retrieved from Ebsco database (2007-30856-681). http://info.euromoney.com.
Comparison between the Conventional Insurance and the Takaful Insurance
A comparison is made below to highlight the salient differences between
conventional insurance and Takaful insurance:
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Conventional Insurers Takaful OperatorsSources of laws & regulations are set by
state and man-made.Sources of laws are based upon Divine revelations (Holy Quran and Hadith)
Profit-motive, maximizing returns to shareholders.
Community well-being optimizing operations for affordable risk protection as well as fair profits for the operator.
Profits and/or Bonus units to be returned to policyholders as determined by managers
and Board of insurer.
Takaful contract specifies in advance how and when profit/surplus and/or
Bonus units will be distributed .
Initial capital supplied by shareholders.Initial capital supplied by Rabb al Mal (Agent) or paid in via premiums from
Separation of policyholder and insurer with differing interests.
Coincidence of interests between policyholder and operator as appointed
Transfer of losses among insurance pools and from policyholders to shareholders.
Losses retained within classes of business written and sole obligation of
Right of insurable interest is vested in the Nominee absolutely in Life insurance.
Right of insurable interest is determined by Islamic principles of Faraid
(inheritance).Insured may elect cost or replacement cost valuation and claim accordingly whether or
not they chose to rebuild property.
Insured may not "profit" from insurance and entitled to compensation only for
repair or rebuild or replacement.Agents and Brokers are typically
independent from insurer and paid a fee from the premium charged to policyholders that is
not disclosed that is not disclosed.
Agents are employees of the Takaful and any sales commission should be
Investment of premiums conducted by insurer with no involvement by
Takaful contract specified under principles of al Mudharabah how
premiums will be invested and how results are shared. Under al Wakalah, similar practice plus Participant can direct his investments into a range of
unitized funds.Insurer invests premiums consistent with profit-motive with no moral guidelines;
hence co-existence of Al Riba and Al Maisir.
Takaful invests premiums in accordance with Islamic values and
Dissolution - reserves and excess/surplus belong to the shareholders.
Dissolution - reserves and excess/surplus could be returned to
Participants, although consensus opinion prefers donation to charity.
Taxes - subject to local, state, and federal taxes.
Taxes - subject to local, state and federal taxes (if any) plus obligated to arrange annual tithe (Zakat) donations
to charity.Benefits paid from general insurance account
owned by insurer.Benefits paid from contributions(Al
tabarru) made by participants as mutual
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Accounting consistent with GAAP and prevailing statutory rules Auditing for
uniform application of accounting standards.
Accounting standards consistent with national rules (with may be GAAP)
plus prevailing statutory rules. Auditing same standards plus conformance with
Islamic rules; typically with Sharia Advisory oversight.
Conclusion and Recommendation
Insurance, especially life insurance is an essential part of the social protection
needed for any society. It has its rightful place in Islam but years of misunderstanding
and misconception have created mental blocks against insurance in the Muslim
culture. I believe Takaful or Co-operative Insurance is the right way forward towards
the breakdown and removal of such mental blocks. This type of insurance has great
deal to offer in Muslim countries where the spread of insurance per person and per
Syrian pound of GDP can increase manifold if the system of Takaful is projected
correctly and understood properly. It can genuinely enlarge the insurance market in
areas where traditional insurance has not been able to grow, as it should have done.
This is true of personal lines, especially of life insurance or family Takaful.
In order to create the essential trust and confidence, which is needed to remove
the mental blocks just mentioned, the efforts to develop and manage Takaful business
must be genuine. Investors, entrepreneurs, and insurers have good opportunity to take
up the challenge of developing insurance business on Islamic principles. After all
Takaful is intrinsically in accordance with the indigenous consumer needs.
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Ashton, M. (2008). Islamic market presents challenges. Journal of Fin Week. 17 (2),
64-65. Retrieved from Ebsco database (2008-34383-663).
Bodie, Z., Kane. A., & Marcus, A. (2007). Essentials of Investment. United States:
Dirrheimer, M. J., & Sohail. J. (2008). The potential of Bancatakaful. Journal of
Financial services. 39 (2), 14-15. Retrieved from Ebsco database (2008-30059-281).
Dorfman, M. S. (2007). Introduction to risk management and insurance. Canada:
Insurance. (n.d). Retrieved June 2, 2009, from the WiKIPEDIA Wiki:
Jones, M. (2008). The Next Step. Journal of Global Insurance. 109 (6), 145-148,
Retrieved from Ebsco database (2008-34928-004).
Kwon, W. J. (2007). Islamic Principle and Takaful Insurance: Re-evaluation. Journal
of Insurance Regulation. 26 (1), 53-81. Retrieved from Ebsco database (2007-30856-
Takaful. (n.d). Retrived June 2, 2009, from the WIKIPEDIA Wiki:
18Conventional and Islamic Insurance Systems