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OUTLINES
Sources of the Shariah Framework of Islamic Finance Shariah, Fiqh & Muamalat Necessary Requirements of Islamic Finance Riba, Gharar, Maysir & Others Essential Contracts in Islamic Finance Products and Instruments
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Primary Sources
The
Holy Quran
Sunnah
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Secondary Sources (mostly by the exercise of Ijtihad (reasoning by the learned)) Ijma (Unanimous decision of the Ulama) Qiyas (analogy) Istishan/ Istihab (equity in Islamic law) Maslahah (necessity of the people) Surdul Daraih (Blocking the means) Uruf (custom)
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In general, the framework of Islamic finance is the same framework used by the conventional finance practices. These frameworks are, inter alia legal and regulatory framework, taxation framework, accounting and auditing standards, etc. Might have different or additional framework, such as accounting and auditing standard, etc, due to its peculiarity. In certain jurisdiction, Islamic banking and finance might be regulated by different sets of regulations, either separate or additional, e.g. IBA 1983
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CONTD
However, Islamic Finance, as the name suggests, has another framework, which is considered the major element that differentiates IBF from the conventional banking and finance. Any violation of this framework will definitely effect the validity of Islamic finance itself. Shariah Compliance Framework
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Shariah, in this sense, is wide and encompassing various branches of Islam Normally, it comes in its generality and it emphasizes only on the principles and not the detailed rules (not all the time) It is the duty of the judge (qadi), mufti and jurisconsult (ulama) to exert their intellectual efforts in deriving and applying these principles on certain given scenarios. The result of human reasoning and understanding to the shariah is known as fiqh Fixed v. Flexible Agreements v. Differences
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However, in its general usage, it is called al-syariat alIslamiyyah (Islamic law). Islamic commercial law is one of the components of Islamic law Other components of Islamic law include:
Islamic law of purification and worship Islamic family law Islamic criminal law Islamic law of evidence and procedure Islamic law of inheritance, etc
The main subjects of Islamic commercial law are commercial contracts and the rules governing them
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In Islamic jurisprudence, the main source of law is the Shari`ah or Islamic law as contained in the Quran and Sunnah Underlying rule: all contracts are deemed permissible except when there is contravention of any established principles of Islamic law / Shari`ah Legal maxim (qa`idah fiqhiyyah):
Al Asl fi al `Uqud al Ibahah -the original rule in contracts is permissibility
The parameter: Avoidance of any contravention of the established principles and prohibitions in Islamic law
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WHAT TO BE AVOIDED
Riba prohibited in many Quranic verses and sayings of the Prophet s.a.w. Meaning: riba is every excess in return of which no reward or equivalent counter value is paid, in short, every unjust enrichment is riba
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and that which you give in gift (to others), in order that it may increase (your wealth by expecting to get a better one in return) from other peoples property, has no increase with Allah
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4:160 - 161
and their taking of Riba though they were forbidden from taking it and their devouring of mens substance wrongfully. and we have prepared... a painful torment.
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3:130
O you who believe, Eat not Riba doubled or multiplied, but fear Allah that you may be successful.
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2: 275
those who eat riba will not stand (on the Day of Resurrection) except like the standing of a person beaten by Shaitan leading him to insanity. That is because they say: trading is only like Riba, whereas Allah has permitted trading and forbidden Riba. So whosoever receives an admonition from his Lord and stops eating Riba, shall not be punished for the passt; his case is for Allah (to judge); but whoever returns (to riba), such are the dwellers of the Fire they will abide therein forever.
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2: 276 - 278
Allah will destroy riba and will give increase for sadaqat (deeds of charity, alms). . O you who believe, be afraid of Allah and give up what remains (due to you) from Riba (from now onward), if you are really believers
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2:279
And if you do not do it, then take a notice of war from Allah and hiss Messenger but if you repent, you shall have your capital sums. Deal not unjustly (by asking more than our capital sums), and you shall not be dealt with unjustly (by receiving less than your capital sums).
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2:280 - 281
And if the debtor is in a hard time (has no money), then grant him time till it is easy for him to repay; but if you remit it by way of charity, that is better for you if you did but know. And be afraid of the Day when you shall be brought back to Allah. Then every person shall be paid what he earned, and they shall not be dealt with unjustly.
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CONTD
There are also a number of narrations from the Sunnah on the prohibition of riba Some of the narrations give general prohibitions of riba, e.g.: The Prophet of Allah s.a.w. cursed the receiver and the payer of riba, the one who records it and the two witnesses to the transaction and said: they are alike (in guilt).
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CONTD
Under Islamic law, riba can occur in two main situations, i.e.:
riba al duyun (loan): the riba or excess which occurs in debt and loan transactions because of extension/delay in repayment riba al buyu` (exchange): the riba or excess which occurs in trading transactions involving the exchange of ribabearing commodities without observing the required rules
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Interpretative Efforts
What amounts to Trade
Criteria Fair exchange of goods or value Fair distribution of risk & return
Usury
Criteria Oppressive / unfair distribution of risk & return Unjustified enrichment at expense of others
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money1 + money1 food1 + food1 money1 + money2 food1 + food2 money + food others + others
Equality Hand-to-hand
2 conditions: =
Equality Hand-to-hand
= = = =
1 condition:
Hand-to-hand
1 condition:
Hand-to-hand
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CONTD
All interest-based lending activities (e.g. all conventional bonds) Fixed return on deposits in conventional banking (e.g. designated accounts for receivables of the bonds) In the secondary trading of debt securities if the transaction is not spot & if there is discounting (according to global Shari`ah standard)
Thus, to be Shari`ah compliant, all contracts in Islamic finance cannot be involved in any of the usurious activities mentioned above
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DIVISION OF RIBA
Riba al-Duyun (RIba in Loan Contract) Riba al-buyu (Riba in exchange contracts )
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RIBA AL-DUYUN
The debtor borrowed money to be paid in certain time, and the amount is more than the amount borrowed A creditor gives a periodic loan and takes monthly interest. The capital sum lasts until the expiration of the period. Upon expiry, if the debtor cannot pay, the period to pay back the capital will be extended and interest will be charged Arising out of exchange contract, a buyer must pay a consideration. If he failed to settle on time, the period will be extended by increasing the amount (principle + interest).
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RIBA AL-BUYU
Mainly based on the saying of the Prophet: Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt; like for like, hand to hand, in equal amounts; and any increase is riba.
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CONTD
These commodities can be classified under two main categories which make the illah (ratio decidendi) for their prohibition: - i- medium of exchange (currency): Gold and Silver -ii- Staple foods: Wheat, barley, dates and salt Any other items, even though not mentioned in the hadith but serve the same purpose will be considered as having the same illah by way of qiyas (analogy)
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Riba al-duyun in loans and certain controversial contracts (bay al-inah, bay al-dayn, etc)
Riba al-buyu mainly in bay al-sarf (exchange of currencies)
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Meaning of gharar: - Literally: risk, uncertainty, hazard - The sale of probable item whose existence or characteristics are not certain, due to the risky nature which makes the trade similar to gambling
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Sale of fish in the sea, birds in the sky Sale of unborn calf in its mothers womb Sale of runaway animal, slave Involve item which may or may not exist However, the Prophet did not lay down the principles (qawaid) for the prohibition of gharar. Examples given in the hadith were some of the manifestations of the doctrine, but not principles. This has led to the dispute among jurists on the area and coverage of gharar.
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GHARAR
Meaning: has a range of negative connotations, such as, uncertainty, deception, risk, hazard, ignorance etc. If there is gharar, the contracting party/ies do not really understand the attributes / consequence of the contract Under Islamic law, gharar is prohibited because its existence in the contract may deny the parties of equal bargaining power and they cannot make informed decisions; or if there is risks on deliverability of the object of the contract
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PROHIBITION OF GHARAR
Surah an- Nisa: ayat 29
squander not your property amongst yourself unjustly (batil) except it be a trade among you by mutual consent
Criteria
All illegal & defective elements in contracts including gharar & uncertainty
Criteria
Offer & Acceptance, indicating consent Elimination of mistake, fraud etc
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The sunnah uses the word gharar and its derivatives much more extensively than the Qur`an in the sense that several new meanings are added In relation to commercial transactions, the Prophet s.a.w. in many of his sayings directly prohibited the sale involving gharar (uncertainty) and jahalah (ignorance) Thus, the prohibition of gharar is made conclusive by the sunnah / hadith of the Prophet s.a.w. Examples: the prohibition of gharar sale (i.e., the sale contract affected by gharar), the prohibition of the sale of fish in the sea, bird in the air, unborn animals, lost items, etc.
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CONTD
Only major /excessive gharar will affect the validity of contracts, where it will render the contract void / voidable, depending on the degree of uncertainty Gharar affects trading and exchange contracts (mu`awadat); not charitable and unilateral contracts In banking & finance gharar can be triggered e.g. in the sale contract to create the indebtedness if the asset used is uncertain / vaguely identified; the trading of a securitised debt which is unconfirmed / not established, sale of insurance policy
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APPLICATION OF GHARAR
Broadly speaking, gharar will effect the validity of contract if it occurs in these areas: - gharar in kind / type / attribute / quantity of the object - gharar due to delivery time - gharar due to the price/ mode of payment - doubt over the ability to deliver
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THE BENCHMARK
Gharar which is excessive (gharar fahish) occurs in exchange contracts (uqud almuawadat) To prevent gharar, the parties to contract must have adequate knowledge and information on the subject matter: i- Their existence and deliverability ii- Its quality, quantity and attributes are known iii- Time frame for payment and delivery
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TOLERABLE GHARAR
However, gharar is tolerable if: - i) it is trivial (gharar yasir) - ii) It occurs in other than exchange contracts, such as in gratuitous contracts. -iii) It happens to the ancillary object (appendages) only (not the principal and main subject matter of contract) - iv) the economic need for the contract embodying the risk is substantial
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Involves the creation of risk for the sake of risk A combative relationship between two contracting parties, each of whom undertakes the risk of loss and the loss of one means gain for the other Apply to all games of pure chance No economic activities are gained in the practice. The gambler will simply seek to amass wealth without efforts. Gambling is gharar in its worst scenario. Prohibited by al-Quran in Surah al-Maidah (5:90)
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Underlying principles utilised in devising products of IBF is very important as they separate IBF from conventional products. Contrary to conventional finance, which is specification driven product, Islamic finance is more structure and principle based product Rules and regulations will differ from one product to another, depending on the structure employed In general, various underlying Shariah principles have been utilised in devising products of Islamic Banking and Finance. They can be summarised as below: - Sale based products - Lease based products - Participatory products - Fee based products
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Mutual consent
Avoid
Interest (riba)
Uncertainty (gharar)
Gambling (maysir/qimar)
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The Quran encourages work and trade The Prophet (s.a.w.) himself was a trader The encouragement of trade is evidenced by the many instruments of trade available during the Prophet's lifetime and in Islamic history thereafter
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Contracts of sale and purchase (bay`), including all its subdivisions, like:
normal or spot sale mark-up sale (murabahah) deferred payment sale (BBA) sale with advance payment but deferred delivery (bay` al salam) sale for future delivery of goods with flexible payment of the price or manufacturing contracts (bay` al istisna`) sale of currency (sarf), etc.
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CONTD
Sell and buy back (bay al `inah) Sale of Sale of debt (bay` al dayn)
Islam recognises partnership contracts which are mainly based on profit and loss sharing (PLS), e.g.:
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CONTD
Leasing (ijarah) - private; Endowment (waqf) private/public; State treasury (bayt al mal) public. Operational lease Financial lease AITAB (hybrid contract)
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to provide security to the parties in a contract, i.e., the contracts of security (`uqud al tawthiqat), e.g.:
suretyship/guarantee (kafalah): involves three parties mortgage (rahn): involves two parties
These security contracts are normally combined with other types of contracts, e.g.:
the contract of BBA may be secured by a contract of security involving collateral (rahn) contracts of trusts (al amanat), e.g.: safe-keeping (wadi`ah) contracts to do a specified task, e.g.: commision (ju`alah); agency (wakalah)
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Gratuitous Contracts
Trading Contracts
Investment Contracts
Supporting Contracts
Gift
Leasing
Sale
Mudarabah
Kafalah
Waqf
Loan Ibra Operational Lease Financial Lease Bay` Bithaman Ajil (BBA)
Musharakah
Rahn
Hiwalah Wadiah
Murabahah
Wakalah Salam Istisna etc. Jualah Muqasah
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Islamic Banking
SOURCES OF FUND
APPLICATIONS OF FUND
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EQUITY FINANCING
DEBT FINANCING
Mudharabah Musharakah
Lease Based Financing Fee Based Services -Ijarah Wakalah -AITAB Kafalah
Comsumer Banking
Corporate Banking
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Equity Market
Bond Market
Musyarakah Mudarabah
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CONCLUSION
Besides various frameworks applied to banking practices (be it Islamic or conventional), Shariah framework is a framework which is peculiar to Islamic finance alone Yet, it forms the very substance of Islamic finance, without which Islamic finance will loss its Islamicity As such, in practicing Islamic finance, the dos and donts must be clearly observed Islamic commercial law, from the fact that it subjects to human interpretation and understanding admits differences of opinion, as long as these differences are grounded by valid evidence, produced by capable personnel, done according to the right methodology
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TAKAFUL
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Derives from the word Kafalah, a verb, which means to bail, guarantee, warrant or to secure ones need. Means Joint Guarantee. An arrangement between members of community to jointly guarantee each other should mishaps befall to any of them
FOR MORE INFO...
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National Fatwa Committee in Malaysia resolved that the present-day life insurance business provided by the conventional insurance companies was not in line with the principles of Shariah as it contains elements which are against Islam such as Riba (Usury), Gharar (uncertainty) and Maisir (Gambling). ~~~ June 1972
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Perak Fatwa Committee subsequently also declared that: life insurance is not permissible as it is based on riba from which the profits of policyholders are derived. The policyholders must pay premiums for an indeterminate period which lead to the element of gharar (uncertainty).
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TAKAFUL PIONEERS
Takaful started some 30 years ago in the Middle East with the launching of two companies in 1979:
The Islamic Arab Insurance Co. (IAIC) in the UAE and The Islamic Insurance Co. of Sudan
But it took some time for the movement to take shape. Later in 1984, Malaysia played a pioneering role in setting the first Legal framework specific to Takaful (Takaful Act Malaysia). This was instrumental in the successful launching of the Takaful movement in Malaysia and in other countries of South
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TAKAFUL TODAY
From a handful of operators two decades ago the Takaful movement has blossomed into a fast growing phenomenon in many Muslim countries with very promising prospects in other countries with a large Muslim community.
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TAKAFUL DRIVERS
This movement is driven by a strong demand from a public who would not insure otherwise (because of religious beliefs); and The successful development of Islamic banking institutions providing capital and Islamic financial instruments for asset management and investment.
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TAKAFUL DRIVERS
Islamic banks and financial institutions play a strategic and important role in the distribution of Takaful products (especially Life Takaful Products). Just as Bancassurance played an important role in the distribution of personal lines insurance products Bancatakaful is an important driver for Takaful.
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TAKAFUL WORLDWIDE
The number of Takaful operators worldwide is now estimated at: 150 Takaful companies operating in 40 countries 10 Retakaful companies and 6 Conventional Reinsurance companies have established Islamic windows. Takaful is one of the fastest growing segments in insurance (at around 20% pa. on average) World Takaful contributions are conservatively estimated at around US$ 3billions, of which:
60% General Takaful 40% Family Takaful
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South&
56% 36% 7% 1%
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Takaful Business is based on the concepts of Mudarabah and Tabarru. Involvement of these two Islamic forms of business eliminates the elements of Riba from insurance contract and convert Gharar into tolerable form.
In Family Takaful each Takaful installment is divided and credited into two separate Accounts namely, the Participants' Account(PA) and the Participants Special Account(PSA). A substantial proportion of the installments is credited into the PA solely for the purpose of savings and investment.
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The balance of the installments is credited into the PSA as `tabarru' for Sharikah Takaful Malaysia to pay the Takaful benefits to the heir(s) of any participant who may die before the maturity of the contract. The amount accumulated in the PA is invested in various business according to Islamic financing techniques, and the resultant profits are divided between the company and the participants according to the agreed upon ratio, e.g., 30-70. The participant's share is calculated according to their individual share in the PA, and credited into their respective accounts, the PA and the PSA.
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PA
Participant
PA
FTF
PSA PSA
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PAYMENT OF CLAIMS
Should the Participant die or suffer Permanent and Total Disability in the fifth year of participation, Takaful benefit will be paid in the following manner:
i. From Participant's Account =RM 4,890 (RM978 x 5) profit if any, say RM 400 ii. From Participants Special RM 5,000 Accounts (RM1000 x 5) Total Takaful Benefit Payable RM 10,290
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MUDARABAH MODEL
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General Takaful
COMPANY
INVESTMENT BY COMPANY
OPERATIONAL COST OF TAKAFUL PARTICIPANT TAKAFUL CONTRIBUTI ON PAID BY PARTICIPANT GENERAL TAKAFUL FUND GENERAL TAKAFUL FUND
OPERATIONAL COST OF TAKAFUL
SHARE OF SURPLUS FOR THE COMPANY SURPLUS (PROFIT) 40% (Example Only) 60% (Example Only)
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WAKALAH MODEL
COMPANY
40% TAKAFUL CONTRACT BASED ON PRINCIPLE OF AL-WAKALAH INVESTMENT BY FUND PROFITS FROM INVESTMENT 60% OPERATIONAL COST OF TAKAFUL / RETAKAFUL GENERAL TAKAFUL FUND OPERATIONAL COST OF TAKAFUL OPERATIONAL COST OF TAKAFUL SURPLUS (PROFIT) SHARE OF SURPLUS FOR THE PARTICIPANT 100%
PARTICIPANT
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Waqf Model
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DEFINITION OF WAQF
Waqf is an Arabic word and it means to stop to withhold and not to let go. In technical meaning Waqf means to allocate or donate some property or cash for a specific purpose to get pleasure of Allah and not to let it go through consumption or sale. The Waqf property comes into ownership of Allah (SWT) and Waqif will have no property rights on it.
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Waqif has right to set the rules for Waqf and manage the Waqf. Waqf may be general purpose or specific purpose, like Waqf Ala al Aulad or Waqf Ala al Aqarib. In Islamic Law Waqf is a legal entity
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WAQF MODEL
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COMPANY
TAKAFUL OPERATOR FEES FOR ADMIN & MARKETING EXPENSES 25% TO 35%
Waqf
TAKAFUL CONTRACT BASED ON PRINCIPLE OF AL-WAKALAH PARTICIPANT
Waqf
INVESTMENT BY FUND
WAQF FUND
SURPLUS (PROFIT)
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A Waqf Fund would basically be a separate legal entity to which the Shareholders would initially make a donation to establish the Waqf Fund. The donation can be of any reasonable amount (Shariah Board may specify such an amount). The objectives of the Waqf fund would be to provide relief to participants against defined losses as per the rules of the Waqf fund.
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In this modified Wakala Model with Waqf, the relationship of the participants and of the operator is directly with the Waqf fund. The Operator is the Wakeel of the Waqf Fund and the participants pay one sided donation to the WAQF fund (not conditional) which also eliminates the issue of Gharar. The WAQF fund rules may define the sharing of surplus and other rules under which it would operate but there is no obligation to distribute surplus. Further the Qard would be given by the shareholders to the WAQF entity and not to individuals as in the typical Wakalah model.
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FUTURE OUTLOOK
Despite the remarkable growth rate recorded by Islamic finance and Takaful industry, penetration is still far below the enormous market potential offered by the Muslim community worldwide (23% of the total world population).
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GROWTH OUTLOOK
World Muslim population is estimated at 1.5 billions, of which around 97% are based in Asia and Africa. A two-digit growth in the range of 15% to 20% can be reasonably sustained for at least the next 10 years in the existing markets (Far and Middle East).
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CONCLUSIONS
Despite the challenges facing this new industry, exciting times are ahead once the latent potential is unleashed. The success of Takaful largely depends on that of Islamic Financial institutions on a global basis.
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Mohd Johan Lee J. Lee & Associates A-16-13, Tower A, Menara UOA Bangsar 59000 Kuala Lumpur
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