5.2 Risk-Mitigation Mechanisms Available to Low-Income Individuals

How do low-income individuals smooth their consumption without access to formal financial markets? We distinguish between two types of risk-mitigation strategies available for consumption-smoothing: ex ante risk management and ex post risk coping strategies.[1] Ex post mechanisms aim directly at consumption smoothing during a crisis while ex ante risk coping strategies aim at the advanced deployment of strategies to smooth income downturns and therefore, indirectly consumption before a crisis strikes.

In the absence of formal insurance and limited or non-existent public safety net, informal risk-sharing arrangements become vital in ex post risk mitigation. Borrowing, intergenerational or interfamily transfers in the form of loans, cash or in kind can help a household weather a downturn in income. Community-based insurance mechanisms, such as the burial societies discussed in Section 4.1, can help a family smooth consumption in the presence of an idiosyncratic shock, i.e., a shock which affects the particular family but not the community in general such as an accident that renders a specific breadwinner unable to work. However, when income shocks are correlated so that the incomes of households in a community move in a tandem over time, community-based risk pooling arrangements are less effective in mitigating risks.

Example 8: Covariate Risk

One well-known example of the limitations of community-based safety nets is the drought and famine in the Northern Wollo region of Ethiopia in the mid 1980s. The rural community tried to use their livestock, a traditional buffer asset, to cope with the disaster. However, the excess supply of livestock coupled with low demand led to a collapse of livestock prices. The crisis was further exacerbated by rising crop prices.

Informal risk-sharing arrangements cannot be considered insurance because they are typically reciprocal in nature. Unwritten, but well understood customs and traditions dictate that the beneficiary of community support today reciprocates this aid in the future. This reciprocal nature of informal insurance mechanisms creates the possibility of corruption and nepotism if the aid recipient today is in a power position in the future. Corruption stifles investment and therefore, the accumulation of capital, which can have a negative effect on economic growth.

To a large extent, ex ante risk management strategies depend on the ex-post risk coping mechanisms available to a household. For example, a large and better socially integrated household with significant asset holdings and access to formal financial markets may feel well insulated against an income downturn. However, even a small income shock can be detrimental for a poor and socially excluded household. Decision-makers in such a household devise strategies ex ante to smooth their income so as to smooth their consumption. This can affect both the choice of occupation as well as savings and investment decisions, ceteris paribus. For example, an empirical study based on western Tanzania in 1990 finds that poorer households derive a larger share of their income from off-farm activities and raising crops compared to more affluent families.[2] However, these activities tend to have a lower expected return compared to the riskier cattle raising. The author rules out risk aversion and comparative advantage as potential explanations for this behavior but attributes it instead to income risk and the inability of low-income households to borrow when needed to smooth consumption.

Therefore, the purchase of microinsurance coverage, which reduces income uncertainty, has the potential to encourage low-income individuals to take up occupations which are more in line with their comparative advantage and risk tolerance thus accelerating human capital accumulation and possibly, productivity growth. Further, microinsurance can enable credit-constrained entrepreneurs to invest in profitable but risky ventures, such as modernizing their farm production or introducing new production technologies, which require a long learning period, thus channeling assets to their most productive uses, accelerating the rate of physical capital accumulation and, therefore, economic growth.

Inequality and economic growth are intricately linked. “[T]he conventional textbook approach is that inequality is good for incentives and therefore good for growth.”[3] However, there is mounting empirical evidence to the contrary. Ex ante risk management has a perverse effect on the income distribution in a country over time. By investing in low-risk, low-return activities, poorer households perpetuate poverty and widen the gap between the rich and the poor. In contrast, by enabling the poor to enter higher-risk, higher-return occupations, enlarge their existing businesses or start up new businesses, microinsurance may help close the gap between the rich and the poorer, and therefore, accelerate economic growth.

In summary, there are many channels through which microinsurance can impact economic growth. However, capturing the effect of microinsurance on growth in the data is challenging for three major reasons. First, the impact of microinsurance, particularly through human capital accumulation, may take years to be reflected in official growth statistics. Second, many if not most of the poor are not employed in the formal sector and carry out a limited amount of market transactions. Therefore, their contribution to the aggregate output may not be tracked by official government statistics. Finally, data on microinsurance take-up rates are difficult to find.

Flashcard Activity

  1. Morduch and Sharma (2002)
  2. Dercon (1998)
  3. Aghion et al. (1999, p. 1615)


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