Islamic finance has developed in two main directions namely Islamic banking and Islamic Insurance. Takaful insurance (also known as Islamic insurance) is not only an innovative approach to Islamic finance, but also a viable alternative to conventional insurance. Takaful – the Islamic way of insurance is always based on mutual protection and co-operation between its members. From this joint benefit and shared responsibility, Takaful brings equity to all the partners involved in the operation.  In Takaful insurance all the members contribute money into a pooling system in order to guarantee each other against loss or damage. The main objective of this Takaful insurance is not to gain profit but to keep the principle of mutual support and shared responsibilities to take precautions against risks and misfortunes for all individual constituting the group. Here, Funds collected through Takaful premiums are channelled into Shari’ah compliant investments that involve environmentally friendly and socially responsible business activities. Most of the profits from these funds are shared among the participants.

Takaful insurance is different from conventional insurance in many ways. The main difference is its fundamental principles that govern each activity in takaful insurance. The main fundamental principle is that the transactions that involved Riba, Gharar and Maysir are prohibited in Takaful insurance.

Riba  - Any amount that is charged in excess which is not in exchange for a due consideration

Gharar – Contractual uncertainity that leads to dispute

Maisir – The element of speculation in a contract

All the above Riba, Gharar and Maisir are mostly present in a conventional insurance. Conventional insurance involves the exchange of excess between insured’s premium and the insurer’s payment against the claim, this will lead to “Riba” in insurance contract. “Gharar” also involved in conventional insurance because in conventional insurance the insurer has a right to profit from the investment of insurance premiums and the other party, the insured, does not have excess to its funds. Conventional insurance also involves “Maisir” i.e. element of speculation in a contract because in conventional insurance the insured pays a premium expecting a much greater amount in case of loss, but loses the entire premium when an uncertain event does not occur

Takaful business is based on a very special mechanism of profit and loss sharing called mudarhabah. This mechanism helps to avoid the element of riba as it is, which is inherent to conventional insurance. Takaful unlike conventional insurance prevents from violating the terms of inheritance prescribed by Shariah.  Takaful contract may comprise clauses for either protection or savings/investments or both the benefits of protection as well as savings and investment. The protection part of Takaful works on the donation principle according to which individual rights are given up to cover the losses equally. In the Savings part, individual rights remain intact under Mudarabah principle and the contributions along with profit (net of expenses) are paid to the policyholders at the end of policy term or before, if required by him. Takaful companies undertake only Shariah compliant business and the profits are distributed in accordance with the pre-agreed ratios in the Takaful Agreement. Likewise they share in any surplus or loss from the pool collectively.

The basic structure of a takaful arrangement is as follows: (1) a takaful company is organized; (2) members make periodic payments that the company maintains in individual accounts for each member;

(3) these amounts are invested in Islamically sound financial products. As part of the contract, the members agree that if any of them suffer a covered loss, then each will make a proportionate gift from their accounts to cover that loss.