PREVIOUSLY we discussed three Islamic world views of financial planning, namely:
Financial planning is Worship (Ibadah);
Wealth is a Trust (Amanah) from Allah that must be administered properly;
Wealth is a major means to achieve al-Falah.
And we said that the four major Islamic financial planning components are derived from these world views.
In this article we will look at the first component: Risk Management and Takaful, and how it relates to financial planning.
To start, let us bring wealth management into the discussion. For simplicity's sake, let us treat wealth management and financial planning as being the same. Wealth management has been described as an advanced type of financial planning but the concept - as opposed to the practice - is the same.
Risk management and Takaful relate to issues in wealth protection.
Conventionally, wealth protection is carried out through the purchase of an insurance policy. In Islamic wealth management and financial planning however, wealth protection is done through participating in a Takaful scheme.
In general, taking up an insurance policy or a Takaful scheme is the same; that is, the client or beneficiary will receive compensation for the sum assured should any peril befall him or her. However, there are fundamental differences between conventional insurance and Takaful in concept and practice.
We shall discuss these differences, but let us, for now, discuss risk management first to gain a better understanding of wealth protection.
Most people see risk as something unfavourable. In finance, risk is often defined as uncertainty of returns. However, this is only true when we talk about investment risk and wealth accumulation. Since this narrow understanding is quite common, let us define risk properly, especially in the broader context of financial planning.
Risk is the possibility of suffering harm or loss. Risk can be assessed qualitatively or quantitatively, depending on specific applications and situations. Examples of commonly used terms to described risk include credit risk, forex risk, political risk, HIV risk, etc. However, since our subject is wealth protection, we will restrict our discussion to risks in relation to assets used in the production of an income and the earning capacity of a person.
Risk can be divided into two categories: Pure and speculative
Pure risk is a category of risk in which loss is the only possible outcome and there is no favourable result. In speculative risk, there are three outcomes - the possibilities of loss, gain or breaking even.
Investment risk belongs to this speculative category. Examples of pure risk are fires or floods. Loss of service of a key employee or the breadwinner of a family due to death, either through illness or accident, is also pure risk. In pure risk, the extent of the possible loss is unknown.
Risk management and Takaful planning deals with pure risk
The main idea is protection, and this must be well understood first before we bring up the subject of investment returns. In the current practice of the insurance and Takaful industry, a lot of emphasis is given to hybrid products in the form of investment-linked insurance or Takaful products. With hybrid products, the risk management and investment aspects have been bundled together. Terms like capital-protected, capital-guaranteed or guaranteed returns are used freely but the exact meaning largely depends on the contract signed by the consumer. Without proper understanding of risk management, it is quite difficult for the consumer to make an informed decision about the hybrid financial product. Therefore, it is very important for consumers, and sales personnel too, to understand what the products are for and are NOT for.
To manage risks properly, these basic steps are recommended in the risk management process:
* Establish context and define parameters;
* Assess the risks by identification, analysis and evaluation;
* Treat the risks by either transfer, sharing, reduction or avoidance;
* Monitor and review.
In the above process, it is in the third step that an insurance or Takaful solution becomes relevant. In wealth management and financial planning, the risk management process is quite simple for the majority of income earners, but it gets complicated for businessmen, the top management of large companies and high-ranked government officials (commonly referred to as the High Net Worth group).
Let us now discuss the Islamic world view of risk management.
Pure risk is of Allah and Islam encourages risk management
When loss is caused by a hazard, most people accept it as fate. Hazard by definition is unavoidable risk. Death by accident is a hazard that we face everyday. It increases even more when driving during festive seasons. So, is there an Islamic world view on managing risk? The answer is yes, of course.
Consider the following Hadith related by Tirmidhi: One day the Prophet Muhammad (Peace and Blessings be upon Him), noticed a Bedouin leaving his camel without first tethering the animal . He asked the Bedouin, "Why don't you tie up your camel?" The Bedouin answered, "I put my trust in Allah." The Prophet then said, "Tie your camel first, then put your trust in Allah."
To lose an untied camel is pure risk. The camel may or may not be there when the Bedouin returns. Tying up the camel is risk reduction. A tied camel can, of course, still go missing if the animal is stolen but that is another peril altogether. The point is: Islam encourages risk management. The advice of the Prophet to the Bedouin to tie up the camel clearly demonstrates the Islamic position on risk management.
Now that we understand the basics of risk management, let us discuss the core concept of Takaful.
The core of Takaful is the Tabarru' concept
Allah enjoins Muslims to cooperate in doing good things. In the Quran, He says: Help you one another in righteousness (al-birr) and piety (at-taqwa), but help you not one another in sin and rancour. And fear Allah. Verily, Allah is strict in punishment (5:2).
The Takaful industry is an example of such cooperation. Truly, the Tabarru' concept is its core.
Tabarru' is defined by Bank Negara Malaysia as: "Tabarru' is the agreement by a participant to relinquish as donation, a certain proportion of the takaful contribution that he agrees or undertakes to pay, thus enabling him to fulfil his obligation of mutual help and joint guarantee should any of his fellow participants suffer a defined loss. The concept of Tabarru' eliminates the element of uncertainty in the Takaful contract. The sharing of profit or surplus that may emerge from the operations of Takaful is made only after the obligation of assisting the fellow participants has been fulfilled.
Thus, the operation of Takaful may be envisaged as a profit-sharing business venture between the Takaful operator and the individual members of a group of participants."
The Takaful operator acts as a management company of the Takaful schemes, similar to a collective investment scheme structure. The difference between the two is that, apart from management fees, the Takaful operator also earns through a pre-agreed profit-sharing arrangement.
In insurance, there is no concept or practice of Tabarru'. This may explain why some analysts look upon insurance as risk transfer and Takaful as risk sharing solutions in the risk management process.
Takaful originates from the Arabic word "Kafalah" which means "guarantee" or "surety." Thus, the Takaful industry is all about cooperating to guarantee each other against a defined loss; and not about transferring risk to an insurer for the price of a premium.
We have now come to the end of our discussion. To conclude, it is hoped that the brief explanation provided has added to our reader's understanding of risk management and Takaful, and its role in Islamic financial planning.