Rent to Own Leases (Ijara wa iqtina’): Fringe Banking & Financial Distress

Legal Theory Blog posts about Regulating on the Fringe: Reexamining the Link Between Fringe Banking and Financial Distress (Indiana Law Journal, Forthcoming) on SSRN.

I’m interested in the guarantee mentioned below. Does Islamic Finance allow for a guaranteed return, even if done through Lease (Ijara)? Because Islamic Finance is not contained by one single regulatory system, some of the arguments made will be difficult to apply. However, given that Islamic Finance makes a claim of ethical perdominance, can we say that this sort of guarantee goes against the ethical framework Islamic finance is to promote?

Highlights from the abstract:

  • Critics of fringe banking – products like payday loans, pawn loans, and rent-to-own leases – frequently argue that using these products causes borrowers to experience financial distress. This argument has enormous intuitive appeal: Fringe credit is very costly, and usually the borrowers who are forced to use it are already in a serious financial bind. Taking on additional debt and paying high costs for it, the reasoning goes, drives them over the brink.
  • This Article represents the first attempt to uncover the relationship between fringe banking and financial distress by systematically analyzing the structure of fringe credit markets and characteristics of specific fringe credit transactions.
  • I argue that the link between fringe banking and financial distress is dubious. Because fringe creditors cannot rely on borrowers’ credit scores to predict whether they will be repaid, creditors structure fringe credit products to virtually guarantee repayment.
  • Because repayment is guaranteed by the structure of the transaction, it is nearly impossible for borrowers to take on unmanageable debt loads.
  • Policymakers lump fringe credit together with other forms of credit that do cause financial distress, resulting in misguided and overly broad policies.

Consultation, Moral Hazard, & Shariah Boards

While preparing my Masters thesis, I came a across an interesting quote from Muhammad b. Idris al-Shafi’i, the famous jurist and author of the first work of Islamic legal theory, al-Risalah. After explaining the need to consult others before issuing juristic opinion:

[Consultation should be sought] regardless of whether those consulted agree or disagree; in fact those that disagree [with you] should be given priority, so as to help resolve what juristic opinion is applicable. One should ponder over their evidences, then decide. [al-Bahr al-Mudhhab of al-Ruyani 11/170]

Shariah Boards tend to lean towards one legal methodology; that is expected in any decision making group. There has been a trend though to filter opinions until the only thing you are left with are those that you agree with (or should I say, agree with you).

This seems similar to a moral hazard, when a party insulated from risk may behave differently than it would behave if it were fully exposed to the risk. Excluding dissenting opinions would protect any group from the risk of re-evalution, analysis, and reputation risks. If we consider Shariah Boards to be representative of general shareholder assembly, any Shariah Board which is asymmetric in its makeup would seem to be susceptible to a double-sided principal–agent problem.

A possible “Islamic” alternative to Microlending

Muhammad Yunus having won the Nobel prize for economics, Microfinance has become a hot item for many seeking to make money and “lend” a helping hand. Much criticism has surrounded Microfinance, from Muslims and Non-Muslims alike, questioning the ethics and viability of the practice.

Objections generally center on the fact that it is an interest (Riba) based system, loaning out small amounts of money at a very high rate. Exploitation of women is another big concern. The majority of Microfinance and Micro-credit agencies cater solely to women, even though this apparently is a good thing, many of those women act merely as collection agents for the male members of their families who spend the money while the women bear the credit risk. Additionally, dependence on loans leads to circular borrowing and may constitute a minor form of debt slavery, forcing people out of waged work and into the informal economy.

These points aside, the objective here is not to dwell on the objections to or attempt to dismantle this system, but instead to promote a more ethical and credit-safe alternative to such practices.

Many proponents of “Islamic Finance” promote profit-sharing schemes that reduce credit risk and ensure profit-loss equity among the involved parties. One such method that may provide an alternative is called “Credit-Based Mudarabah”.

Mudarabah is an Arabic word for silent partnership,

Sharikat alMuDarabah: a partnership of two parties in which one provides capital and the other provides labor. (For more on partnerships look here)

One method that the researcher mentioned was “credit-based Mudarabah” i.e. a credit-based silent partnership.

Credit-based Silent Partnership

Parties involved:

There will be one party that will provide the labor, known here as the “Agent”. The other party will provide capital, known here as the “Financier”.

How it works:

  1. The agent and the financier enter into a partnership agreement
  2. The two parties agree that the financing will not be provided until
    the business deal is arraigned with the various other parties involved.
  3. Once proof of the deal is presented to the financier, payment is made
    to the third party selling the goods, and profits are shared between the
    financier and the agent.

An example:

  1. Take into consideration this scenario:
  2. An agent purchases concrete for re-sale with the option to
    return or cancel within 48 hours.
  3. He then signs agreements with the purchasers of the concrete for delivery at the specified date.
  4. Upon closure of the deal, he presents proof of purchase for re-sale and
    closure of re-sale to the financier, who then would issue payment to the
    concrete salesman.
  5. Profits from the re-sale would be divided up between
    the agent and the financier.

Benefits of this method:

  1. Cancellation of the last deal would cancel the first, and sales risk
    is minimized.
  2. Credit-risk and risk of failure are brought to a minimum, as are the
    problems of misreporting

Additional considerations:

  1. The method is applicable for both wholesale and retail
  2. If the trade between the suppliers, the agent, and the retailers is constant, then there would only have to be an agreement to supply, with order amounts on a case by case agreement, an OCO (one cancels the other) agreement can be done in case the retailers or the financier defaults, so safety guards are in place.

Islamic Economics vs. Global Capitalism

Islamic Economics is a topic of great interest nowadays. Sometime ago an article appeared in the LA times, asking the question “Will capitalism fall victim to its own success?

From the article:

Karl Marx is turning in his grave. Or perhaps not, because some of his writings eerily foreshadowed our era of globalized capitalism. His prescription failed, but his description was prescient.

I assume that he is pointing to this quote from the Communist Manifesto:

The development of Modern Industry, therefore, cuts from under its feet the very foundation on which the bourgeoisie produces and appropriates products. What the bourgeoisie therefore produces, above all, are its own grave-diggers. Its fall and the victory of the proletariat are equally inevitable

But with all the criticism that can be heaped on capitalism, what are the alternatives? Social Democracy is named, as is Chavez and his “21st Century Socialism”.

Then there is “Islamic Economics”…

From the article:

What, after all, are the big ideological alternatives? …
Islamism — billed as democratic capitalism’s great competitor in a new ideological struggle — offers no alternative economic system (aside from the peculiarities of Islamic finance) and does not appeal beyond the Muslim umma. Most anti-globalists are better at pointing out the failings of global capitalism than they are at suggesting systemic alternatives. “Capitalism should be replaced by something nicer,” read a placard at a May Day demonstration…

Islamism, according to the author ( and I assume meaning the practice of Islam on more than a personal level) is insufficient in developing an alternative economic system. There are more than enough writings on “Islamic Economics” but with economics largely an empirical science, can the ideology of Islam to develop an “Islamic theory of economics” i.e. one that guides the normative values of economics in a manner conducive to Islamic belief and practice?

Much of what has been written in this field is extremely vague. Concepts of “Justice” and “equality” abound, re-iterated with the same examples of prohibiting “Riba” and usurpation of property. In fact, there seems to be a trend in many of these writings. When socialism was big in the Muslim world, many such writings reflect that influence, stressing wealth distribution and state regulation. Nowadays, with the socialist influence waning, more capitalist leaning thought has entered the fray. All in all, there is still alot of research that needs to be done. Economists such as Timur Kuran present the same picture of “Islamic Economics” that the author of the above quoted article does. Others have been equally critical, yet without avail. There seems to be a stagnancy in admitting the need for progression in the area of economics, Islamic economics that is. So while many Muslims believe that they are simply being sticklers for orthodoxy, in fact they may be merely following trends, something alluded to in several hadeeth.

This method of innovation-trailing in areas of economics and finance has lead to no substantial alternative to be developed for the benefit of mankind, much less the benefit of Muslims. While some characterize critique of Islamic Economics as a form of self-hate, hypocrisy, or support for non-Islamic systems, they should recall the statement of Umar ibn AbdulAziz “May God bless the person who presents to me my faults.”

Also from the article:

Does the lack of any clear ideological alternative mean that capitalism’s triumph is secure? Far from it. For a start, the history of capitalism hardly supports the view that it is an automatically self-correcting system. As George Soros (who should know) points out, global markets are now more than ever constantly out of equilibrium — and teetering on the edge of a larger disequilibrium. Again and again, capitalism has needed the visible hands of political, fiscal and legal correction to complement the invisible hand of the market.

So if Islamic Economics is an alternative system, what sort of corrective mechanisms are sanctioned to offset disequilibrium? Most research, as alluded to in the article, has centered on issues of Islamic finance. Issues that for the most part are micro-economic in nature, and do not present an “Islamic” concept of a general regulatory framework or a theory of political economy.

In “The Worldly Philosophers” Robert L. Heilbroner lists three ways in which societies have dealt with such precariousness of human nature: tradition, authoritarianism, and market systems. In the past, it seems that much of the research and application of Islamic law as applies to economics, business and finance seemed to concentrate of the tradition of the Madhahib (juristic schools) and their analysis of the “permissibility of contracts“. As alluded previously, authoritarian attitudes to these subjects took hold in the attempt to develop a viable Islamic counter-culture to what was thought to be the invasion of the “Un-Islamic” ideas of Capitalism and Democracy. Now the only thing left is the development of market system reflecting the objectives of Islamic Law.

What sort of political correctionary methods are sanctioned by Islamic Law? If the Islamic economy is not authoritarian, then is it laissez-faire? What sort of fiscal policy does Islamic economics advocate? Classically this was spoken of in the books of politic or “al-Siyasah al-Shar’iyyah”. However, there is great emphasis in those works on revenue from natural resources and appropriation of war-spoils, with  Zakat and land taxation another large part of that discourse. With modern market economies and the spread of fiat currency, what is the Islamic view of Seignorage? What of taxation? (the latter being a particularly touchy topic in some medieval legal discourse). Many more modern topics would not even be mentioned.

As for legal corrections, this area has been particularly problematic for me. We find that one of the staunchest prohibitions in the Quran to be that of the prohibition of “Riba”. However, all of the punishments and admonishments attached to this form of transaction are of a moral type attached to other-worldly punishment. The question then remains: How can something that is viewed as so severe in its practice, be allotted a punishment that does not even equal that of the least of punishments for misappropriation of personal property (theft, etc.)

Admittedly, I am not an economist, I am a student of Law. If the assertions or assumptions that I have made here are wrong, please let me know. I would love to learn from you.

In closing, the article mentions:

Marx thought capitalism would have a problem finding consumers for the goods that improving techniques of production enabled it to churn out. Instead, it has become expert in a new branch of manufacturing: the manufacture of desires. It’s that core logic of ever-expanding desires that is unsustainable on a global scale. But are we prepared to abandon it?

A good question as many Muslim countries head down the path of Prophecy, importing some of the most detrimental aspects of capitalism without a 1/2 of the social and economic regulations needed to allow for longevity.

Islamic legal development: In spite of vs. in light of

On issues of Islamic legal development theory, one point popped in my mind today when thinking about Ahkam al-Sharikat that is the Law of business partnerships. This point is, and hence the title, is “In spite of vs. in light of”.

What I mean by this is that in the development of Islamic Law, certain aspects of that legal system developed “in light of” the texts. Many if not most of these are things which are explicit in nature, and are related in numbered explicit texts or innumerable implicit ones.

Take for instance the law of Business partnerships. There is a whole array of laws in all of the various books of classical Islamic law regulating this sector of the law. However, upon closer analysis, we find that there are only about 3-4 verses of the Quran if not less, and 10-15 hadith at most that speak on this topic specifically. When they do, it is usually after the fact, i.e. a transaction or partnership was created, a problem was presented, and then the prophetic guidance was given for that problem. That would then necessitate that the law as presented in the sacred texts developed in a reactionary manner to the prominent social convention of the time, and in general presents a broad regulatory framework for the issue at hand.

When we look at the books of Islamic law however, we see that they spell out for us only five types of partnerships (barring the agriculture based ones of Musaqah, etc.). Those five types are:

1- Sharikat al-‘Inan: a partnership of two parties both providing capital and sharing equally in labor.

2- Sharikat al-Abdan: a partnership of two parties sharing equally in labor with no capital investment from either of them.

3- Sharikat al-Wujuh: a partnership between 2 or more people whom enter a mutual liability based on their collective influence to enter a deal.

4- Sharikat alMuDarabah: a partnership of two parties in which one provides capital and the other provides labor.

5- Sharikat al-MufawaDah: Being a partnership that includes all of the previous

Now the presence of these in classical works of fiqh is all fine and dandy. However the problem comes when we wish to apply them to modern forms of partnership such as corporations, LLC’s, etc.

And this is where the differentiation comes in, and draws us to ask some questions:

– Were these forms of partnership decreed by sacred text?

– Or were they conventions that were prevalent at the time?

– If new contracts arise, are we obligated to refer them back to the codified from of these medieval partnerships?

– Or do we look to the texts for broad regulatory guidelines and accept that the base ruling of all contracts and conditions is that they are permissible?

I’ll only take one type of partnership contract here, that being Sharikat al-Abdan.

Sharikat al-Abdan is usually substantiated by the statement of Abdullah ibn Mas’ud who said “Myself, Ammar, and Sa’d were were partners in anything that we gathered on the day of Badr; Sa’d returned with two captives, and Ammar and I returned with nothing.” This was narrated by al-Nisa’i, and is a weak hadith.

The scholars of the Shafi School rejected this form of partnership, while the majority accepted it. Now despite this hadith being weak, lets just say that it was authentic for arguments sake. In fact there may be supporting evidence for it, although I haven’t gone back to look. The scholars of the Shafi School may have rejected it based on the principle that the statements of the Sahabah are not admissible as evidence. They may have considered weak.

Regardless, let’s look at the context of the hadith. It is hardly a prophetically ordained mode of partnership. It is also not conclusive that there was any prophetic approval of the contract.

Even though the majority of scholars may have allowed it based on this statement, it doesn’t follow that we are in need of this statement of that companion to say that this is allowed. Additionally, to designate a distinct type of partnership based on this would also not follow. Leaving the very open ended agreement that “partnerships are permissible as long as there is no harm” would have seemed more conducive to growth of the Muslim economy and in line with the flexibility of Islam.

Those that admitted this statement as evidence for the permissibility of this type of partnership then formulated all types of rulings for default, harm, and profit distribution, etc. and designated various sub-categories of this partnership agreement, all based not on text, but on the convention that was agreed upon in that time and place. Even though this fit the constraints of the era they lived in, it was detremental in that later generations took these rulings to embody Islamic legal canon, and as such everything after that was illegitimate. In essence the Majority of Scholars went the way of the Zahiri school as per contracts and their creation, contradicting themselves in principle.

Shihab al-Din al-Qarafi says:

Holding to rulings that have been deduced on the basis of custom, even after this custom has changed, is a violation of Unanimous Consensus (‘Ijma) and an open display of ignorance of the religion

Here we then see that with the development of this section of law that it developed very much in spite of specific textual guidance in contrast to developing in light of that guidance. Not that that is a bad thing per se, however when convention and custom then changes, it is important to relegate differences and rulings on the permissibility of a said action back to the broad regulatory framework as found in the sacred texts, instead of judging a later period convention according to that of an earlier one.

Anyone seeking to study Islamic Law as relates to Business and finance should then analyze the issues at hand, it being preferable for those capable of doing so to infer directly from the texts their broad maxims that regulate the sector in question, rather than appealing to the authority of the past or invoking the sacrosanctity of discontinued convention.

On The Permissibility of Contracts

The general rule for all contracts, and especially in sales, is validity. Unless something is found deficient then the contract remains valid, such as:

1- one of the contracting parties lacking legal capacity

2- one of the objects of contract containing Riba or Gharar

3- or the fact that the object of sale is expressing forbidden, such as alcohol or pork-derivatives,

4- or the fact that is has no real or nominal value, for example a grain of sand

5- or the time of contract is sacred and as such it is not permissible to contract during, such as after the call to prayer on Friday

If the previous are avoided, any contract is permissible regardless of its structure.

If this view was actually implemented in Islamic finance today, we would probably see a lot more innovation and creativity in financing solutions. However, the system currently in vogue is one that depends solely on medieval contract forms, and any new introduction must be related back to that small pool of medieval approved contracts.

While  reasoning behind this is that Umar, the second caliph of Islam, said “No one will contract business in our market unless he has learned the rulings surrounding sales.”Yet this, at face value, seems to run in the face of the hadith “The greatest of Muslims in sin is the one that asked about something that was permitted and is then forbidden because of his questioning.”

To reconcile the two, it can simply be said that the legislative weight of Umar’s statement is less than that of a statement of the Prophet. To understand this further, the circumstances behind Umar’s statement should be analyzed to see if it applied generally to all transactions or specifically to a certain type.

As a general principle, the statements of the Sahabah are not to be taken according to their general connotations, unlike the Hadith of the Prophet.

Additionaly, it is possible that Umar’s statement was an act of trade regulation, based on the general principle of “preventing harm”, thus a policy and not an expression of substantive law.

Thirdly, the base ruling of all transactions is that they are permissible; this fact is agreed upon by all scholars except for Ibn Hazm of the Dhahiri School. Ibn Hazm held that all contracts must be approved of by God and his Messenger in order for us to use them. Even though the majority of scholars differed with Ibn Hazm in principle, by insisting on medieval contract forms they seemingly agree with him in practice.

This can be seen as mainly the product of the normalization period of Islamic law, which occurred between the 6th to 8th centuries. While this process has benefits in providing a redundant system for litigation and judicial procedure, it had a negative effect on legal research and to some extent social norms and acceptable practice, as everything was relegated back to a era affected by different socio-economic constraints. This system caused even more problems in the pre-colonial period, not allowing the legal systems of Muslim lands to adapt to the challenges that it faced from the rising economic power of Europe.

In conclusion, when looking for the “islamicity” of any contract, we do not need to look far, and many stipulations that were mentioned in the books of Islamic Law were mentioned to help in decision making during dispute resolution, not for product validation and creation.

Price-Based Deferred Sales

Salam (السَلـَـم) is a form of contract that was found in pre-Islamic Arabia. At the time the Prophet arrived in Medina, he found people dealing in this form of trade.

In the Hadith of Ibn Abbas he reports:

The Messenger came to Medina and he found the people making deferred sales in fruit for one to two years, and sometimes. At this he said “Whoever makes a deferred sale, then let him do so according to a known volume or weight, and [for delivery at ] a known time.”

Generally, this form of contract was performed in the following way:

  1. Party A requests from Party B a certain product, specifying it in a descriptive manner in such a way that the price would differ (if in fact at delivery the product does not fit the description)
  2. Party B accepts to deliver the product for X amount of money on a specified date
  3. Party A pays Party B for the product, and waits for delivery on the agreed date
  4. On the agreed date, Party B delivers the product to Party A

This description of course barring circumstances such as inability to deliver, market failures, etc. and the product is deferred while the price is given up front. If delivery is not possible then the money is refunded.

An Example:

  1. Bill goes to the farm, and requests from Jake 100 kilos of grade A California raisins, to be delivered in six months time.
  2. Jake accepts for the price of 10 dollars a kilo, total being $1000 USD
  3. In six months, Jake delivers 100 kilos of Grade A raisins to Bill.

Price-Based Deferred Sales

Similar to this method, there is another method that may be effective for Microfinance which is known as “price-based deferred sales”, where the same structure is used but instead of the product being the object of contract the price is the object.

This is performed in the following manner:

  1. Bill goes to the farm, and requests from Jake 1000 Dollars worth of grade A California raisins, to be delivered in six months time.
  2. Jake accepts and receives $1000 USD from Bill.
  3. In six months, Jake delivers $1000 USD of Grade A California raisins to Bill

Differences between the two:

Price-based deferred sales are contracted by Party A (Bill) in hopes that prices go down per kilos, and the quantity received is more. Party B (Jake) hopes that prices go up, or stay the same.

Benefit here is reciprocal in that Party A benefits from the time value of the money increasing or remaining the same, thus reducing loss. Party B benefits from locking in a maximum that will be paid for the product, i.e. a fuzzy number estimated between (0-1) amounts of raisins.

Despite this presentation of various finance vehicles, it is important to remember that the general rule for all transactions is that they are permissible until a source for their invalidity is found (riba, gharar, sale of prohibited substance, invalid condition). If these are not found, or cannot be conclusively proven, then the transaction is valid.

Caveat Emptor and “As-is” sales

In terms of Islamic Law, defects in an object of sale are of two types:

1- Those that occur naturally, such as a home with a faulty foundation or a car with a cracked head.

2- Those that are initiated by a legislative prohibition; selling ground meat as chicken, when in fact it’s pork, or tying the udder of an animal so as to appear to give more milk.

Both types are considered when adjudicating a dispute. So someone who was sold a set of CD’s in which one was cracked or scratched may have the right to a replacement, but may not have the right to recover for damages, as the market price of the CD set is not adversely affected by one faulty CD and no ill intent can be determined in the sale of pre-packaged media.

The right of the buyer to recover for defects is considered when those defects were present before the period of sale. These are, by consensus, valid causes for litigation and recovery. Scholars differed as to those that appear during the period of sale and before the sale is finalized; Malik saw that the buyer has three days to claim defect after which the claim must be dropped. In cases where the defect does not appear except seasonally or over a long period of time he allotted one year. An example of this would be an animal with mange. If the disease was treated before the sales period and is known to reappear without re-treatment, selling the animal in this case would be cause for anullment of the contract or recovery of damages. The three day period was substantiated by a hadith (judged weak by the opposing opinion) and the period of one year substantiated by precedent found in the custom of the people of Medina. This application may be viewed as similar to the principle of Caveat Emptor in English Common Law although not synonymous.

The Majority (Abu Hanifah, al-Shafi, and Ahmad) saw no difference between the period of sale and that before it, allowing for a claim to res indefinitely. They cite the principle “Presumption of Continuity” (Arabic: istiS-Ha_b al-Ha_l استصحاب الحال). That is if a defect is found, we presume, in order to protect the rights of the contracting party that the defect was present before contractm until proven otherwise.

For “As is” sales scholars held three opinions. The first, held by the Hanafi and Hanbali schools, is that “As is” conditions are permissible, and liability can be disclaimed from every type of defect. The second opinion, held by scholars of the Maliki, Shafi, and Hanbali schools, is that liability can be disclaimed only from those defects that are unknown to the seller at that time. The third opinion, being an alternate opinion held by those mentioned in the second, is that liability can be disclaimed except in the case that they were known before hand. This third opinion is in reality a subset of the second, and as such consideration for only two opinions should be given.

Proponents of the first opinion cite a hadith collected by Ahmad that two men came to the Prophet having disagreed over inheritance that had since expired or dilapidated. After having been warned of the dangers of false litigation and the appropriation of another’s property wrongfully earning that person divine punishment in the next life, they agreed to forgive each other. At this the Prophet told them “Go then, divide your wealth, and be just to each other, then let each of you forgive the other.” The implied meaning of this hadith is that each of them after dividing the wealth in question would then forgive his partner for any defects found in his share, mutually disclaiming all liability.

Those that held the second opinion however countered that this hadith is applicable only to cases of inheritance, which in itself is not a commutative form of transaction. Proponents of the second opinion used case-precedent from the time of the Caliph Uthman, in which two men disagreed about a slave who had some defect that had been sold, the seller disclaiming all liability. When it became clear that the seller would not go under oath that he knew of this defect, the Caliph Uthman, acting as Judge in this case, ruled that the price paid must be refunded to the buyer by the seller and the slave returned.

Insurance Regulation

Classically, scholars categorized contracts as being from one of three types.

  1. Commutative exchange (Mu’awaDat معاوضات) – Involving the voluntary exchange of good, services, and/or both for the purpose of trade. Includes: cash sales, bartering, and currency exchange.
  2. Charitable exchange (Tabaru’at تبرعات) – Involving the voluntary not-for-profit exchange of good, services, and/or both out of the goodwill of the giver. Includes: monetary loans, material loans, gifts, and will & testament etc.
  3. Contracts of record/certification (Tawthiqat توثيقات) – The recording of a right or claim of one party against another. Includes: Liens, pawn certificates, debt records, Kafala, etc

When the question of insurance presented itself to the Muslim world, scholars generally took the position that commercial insurance was prohibited. They based this on the perceived obscurity (Gharar) and gambling (muqamarah) involved in the transaction. A small minority differed with this verdict, permitting all forms of insurance; this opinion however was built more on the permissibility of invalid contracts in certain circumstances rather than a full-fledged theory of insurance. Almost alone in his permitting commercial insurance was Mustafa al-Zarka, a premier Hanafi jurist of the last decade.

On the other hand, most allowed mutual insurance. Mutual companies are owned by the policyholders, while stockholders (who may or may not own policies) own stock insurance companies. A mutual company is, in the simplest terms, where all parties are members of an insurance ‘guild’ contributing to the ‘pot’. These contributions are charitable in nature and are seen as the the collective right of the guild, in which everyone agrees that if one member is faced with adversity or some loss that the money collected will be used to offset that loss.

Now for the problem

When scholars speak on the permissibility of insurance, they usually do so from the viewpoint of the insured. Hardly ever do you hear of criticism of the insurance industry as a whole, and the pricing schemes involved. We are told that commercial insurance is Haram, and that we should all go out and get mutual insurance.

This one-sided solution to the problem of insurance, if not obligated by the authorities, leaves many people high and dry with regards to protecting their personal and business interests.

As a quick side note, in classical Islamic legal discussions, compensation for losses accrued by an individual or a group of investors through natural disasters and unforeseen events beyond their control were usually compensated for by the institution known as “Bayt al Mal” or the state treasury, if not they were taken up by the persons tribal allegiances. The state had the responsibility to ensure the livelihood of its citizens, in that it is the authority which collects zakat, taxes, spoils of war, and is entrusted with the natural resources of the state and the revenue received from them.

Back to the issue of contracts, when we look at insurance practices, and if in fact insurance of any type was a commutative exchange, then if canceled or renewed there should be the option to receive back that money that was ‘contributed’ to the deal. As far as I know, you can not do this with most insurance packages. In this case, you are essentially giving away a portion of you wealth in hopes to receive compensation in the face of future losses without expecting the principle contribution back; exactly what is claimed in the case of Mutual insurance.

If this is the case, there would seem to be no difference between commercial and mutual insurance; in both you will end up receiving the same compensation and in both you will pay a similar amount. What does seem to be of consequence is the use of that money by the insurance company, their ability to cancel the policies of their clients, and their secondary investment of that money for their own profit.

The permissibility of insurance (or lack thereof) would seem to lie in regulation of the industry itself, not in the character of the end-user agreement.

Here’s an example that should bring it a little closer to home:

In silent partnerships (Mudaraba), partners are to share equally in the profit and loss of the partnership. If say, the silent partner specifies for himself some form of profit to the exclusion of the other (who here is performing the ‘work’ involved), then scholars held two opinions as to how the profits should be distributed in the face of this invalid condition (calling this MuDarabah Fasidah مضاربة فاسدة). Some said that this partner should be given salary commensurate to his work. Others said that he should receive the profit commensurate to that which a partner similar to him would receive. The point here is that the working party receives compensation for that which he entered the contract for initially, whether it be profit or salary.

If we were to characterize insurance contracts as a form of silent partnership, or at least hold them in the same light, then the contract is invalidated from one side only, not both. The main issue we should be concerned with then is regulation, and not one pertaining to the permissibility of the end-user entering into such as agreement.

In this case,  it shouldn’t matter to the end-user as to what type of insurance he buys, to what extent he insures his property, and to what extent he receives compensation for his losses. In the end of the day it is all the same, he will receive compensation commensurate to his losses; but will the Insurer receive compensation commesurate  to his effort? I suspect that in both commercial and Takaful structures some form of price gouging happens.

Just as the state should guarantee fair business practice and fair compensation, it should regulate the insurance industry accordingly.