Credit and Insurance

1

• Credit and Insurance
• in Rural Contexts
• Stefan Dercon
• Oxford University

2
Purpose

• To provide a discussion on the relevance of
  credit and insurance in a rural development
  context
• Highlighting why it is hard to do something about
  it
• Provide a framework for thinking about
  interventions.
• Build up this analysis with experience from
  Ethiopia with some of the lowest capital stock
  per rural worker and a high risk environment

3
Outline

• Identifying the Problem?
• -Implications of Lack of Credit?
• -Implications of Risk
• 2. Why difficult to solve?
• The trouble with credit and insurance
• The experience with credit and insurance
• 3. What can we do about it?
• Credit
• Insurance
• Institutional models
• Evaluation

4
1. Identifying the problem

• Asked to focus on supply side of chronic
  hunger, which includes food production, but focus
  of presentation is broader
• On the productive base of rural households,
• and the problem that failing credit and insurance
  markets result in livelihoods
• that are characterized by underinvestment,
  undercapitalization and low risk-taking.

5
Credit and Insurance have much in common

• Credit is a trade between time periods t, t1
• Insurance is trade before and after state of the
  world is known.
• Both are bedevilled by contractual incentive
  problems related to information and enforcement
• Both credit and insurance markets are largely
  missing.
• Wealth is the way out it provides collateral for
  borrowing and provides self-insurance against
  risk.

6
Outline of section 1

• 1.1 Why is lack of credit a problem?
• 1.2. Why is risk and lack of insurance such a
  problem?
• 1.2.1 Risk and Poverty Dynamics
• 1.2.2 Risk as a Cause of Poverty

7
1.1. Is lack of credit a problem?

• Low incomes implies limited savings. Without
  savings, two kinds of credit are needed
• 1. Short-term credit to purchase inputs (such as
  seeds, fertilizer, pesticides, herbicides, hired
  labor). The loan is repaid once the harvest is
  in.
• 2. Long-term credit to purchase land to
• a) invest in productive capital (tools,
  machinery, etc.)
• b) improve land (irrigation, fencing, bunding,
  removal of stumps. etc.)
• c) adopt technology that is risky but, on
  average, is more productive.

8
Implications if no access?

• Inefficiency given the existing technology and
  other inputs, not the highest return
• Underinvestment, undercapitalization losses in
  terms of growth
• Capital per unit labour low and sub-optimal (e.g.
  Ethiopia one oxen per hh)
• Activities with high marginal return are not
  taking place
• Typical market solution, collateral, is a sign of
  market failure.

9
Implications?

• Lack of credit becomes then a cause of poverty
  and a source of poverty persistence stuck in low
  return activities, so low savings next period,
  further stuck in low return activities, etc
• Well understood providing credit to has long
  been a central part of development policy,
  internationally or within the rural sector.

10
1.2. Is risk a problem?

• Parallel with credit
• A source of inefficiency
• A cause of poverty
• Leading to poverty persistence
• Risk and Insurance should be treated with same
  sense of importance as credit
• But interventions are receiving less attention
  try to address this below.

11
Sources?
References supplied. Sources Insurance against
Poverty, Oxford University Press,
2004. Supplemented with newer evidence on
Ethiopia All to be found on http//www.economics.
ox.ac.uk/members/stefan.dercon/research.HTM
12
Risk and livelihoods

• Risk affects
• sustaining assets/endowments
• transforming assets into incomes (activities)
• transforming incomes into welfare outcomes
• Risky events are exogenous to the agent
• Agents dont passively undergo risk and shocks,
  but use risk strategies to shape outcomes

13
Risk and Uncertainty

• Risky events are the
• known unknowns
• Uncertain events are the
• unknown unknowns
• Difference has limited implications for our
  analysis, although implications for policy.

14
Outline of section

• 1.1 Briefly why is lack of credit a problem?
• 1.2. More attention why is risk and lack of
  insurance such a problem?
• 1.2.1 Risk and Poverty Dynamics
• 1.2.2 Risk as a Cause of Poverty

15
1.2.1 Risk and Poverty Dynamics

• Shocks are central to life of many poor
• e.g. Rural Ethiopia, five year period
  (1999-2004) any serious shocks that gave
  hardship? 95 listed at least one.

16
Table 1 The incidence of serious shocks
1999-2004
17
Household actively try to manage risk

• Ex-ante strategies before the risk occurs,
  trying to prevent risk affecting the household or
  to mitigate the impact of risk
• Ex-post strategies after the risky event occurs,
  reducing its impact (coping) (while ex-ante
  preparing for this)

18
Risk strategies

• to mitigate and reduce risk ex-ante
• Diversification, Low risk activities
• Marriage/migration patterns
• to cope ex-post
• Savings as a Precaution (grain storage,
  livestock)
• Informal arrangements to share risk (mutual
  support credit arrangements, insurance groups)
• Family Labour adjustments (incl. children)

19
Impact of shocks?

• These strategies provide some risk-sharing and
  smoothing , but some shocks still matter
  significantly
• e.g. in rural Ethiopia 1999-2004 data, impact on
  consumption in 2004?
• Drought? -13 to 16
• Output price collapse? -19
• Demand for non-agricultural prod? -20
• Serious illness episode in family? -15

20
Impact of shocks?

• Overall contribution to poverty is high!
• -Actual Poverty (with shocks) 44
• -Counterfactual poverty without shocks, or the
  chronically poor 29
• -OR transient poverty as proportion of total
  poverty share is 33

21
Policy conclusion?

• Behind much of the safety net thinking
• there is a rightful place for appropriately
  targeted safety nets for humanitarian reasons to
  help these temporarily poor
• but they are a bit of a luxury and they are not
  near the core of activities to reduce poverty and
  stimulate broad-based growth

22
Policy conclusion, ignoring the link between risk
and poverty

• Not just risk causes welfare fluctuations but
• Principle Uninsured risk is costly and may
  have persistent (long-lasting) or permanent
  effects on poverty and human development

23
Outline of section

• 1.1 Briefly why is lack of credit a problem?
• 1.2. More attention why is risk and lack of
  insurance such a problem?
• 1.2.1 Risk and Poverty Dynamics
• 1.2.2 Risk as a Cause of Poverty

24
1.2.2 Risk as a cause of poverty

• Two ways in which risk causes poverty
• ex-post impact of risk
• ex-ante or behavioral impact of risk
• Risk may cause ex-ante and ex-post serious
  losses in terms of growth and poverty reduction,
  since it may lead to poverty persistence and traps

25
Risk as a cause of poverty the ex-ante impact

• Uninsured risk implies that it may be optimal to
  avoid profitable opportunities. So, lower risk at
  the expense of lower returns (less efficient)
• E.g. Diversification, low risk activities, low
  risk assets
• -NOT due to risk averse preferences but driven
  by lack of insurance (constraints)
• -even possibly choosing to be poor by lack of
  options

26
Risk as a cause of poverty the ex-post impact

• Shocks resulting in lost human, physical or
  social capital, reducing access to profitable
  opportunities in the future.
• - examples loss of livestock/assets
• stunting and lower educational attainment from
  poor health and nutrition breakdown of social
  networks etc.

27
Examples (1) ex-post impact of shocks

• nutrition temporary hunger leading to
  stunting, lower school attainment, earnings
• E.g. Zimbabwe, impact 82/83/84 drought/war.
• Shock on children, 16 years later 7 percent loss
  of lifetime earnings.
• recurring theme in many life histories across
  developing world

28
Examples (1) ex-post impact of shocks

• Impact of HIV-AIDS shocks on orphans
• in Tanzania, we find strong impact of the death
  of a mother during childhood on adult height
  later,
• and on educational attainment at adulthood,
  suggesting a permanent impact of the shock.
• In Ethiopia food consumption effects
• persistent impact of drought in 84/85
• those seriously affected then, experienced
  significantly lower growth (minus 10-15) in 1990s

29
Examples (2) ex-ante impact of risk

• YES
• many studies find significant effects, few
  quantify this fully
• investment impact of risk could be physical,
  financial, or human capital
• studies in rural South India
• providing the lowest wealth groups the same
  protection as the highest wealth groups,
  results in 25-50 higher return per assets,
• due to portfolio effects
• rural Zimbabwe
• quantified micro growth effect,
• suggesting 40 lower capital stock, substantially
  due to ex-ante effects

30
Examples (2) ex-ante impact of risk

• Tanzania
• providing the lowest wealth groups the same
  protection as the highest wealth groups,
  results in almost 50 higher return per assets,
  
• due to portfolio effects
• Fertiliser uptake in Ethiopia
• application rates substantially lower because
  farmers inability to cope with consequences of a
  drought and its consequences
• fertiliser application rates would be up by 43
  percent, if downside risk were to be reduced by
  one standard deviation.

31
Conclusions?

• Risk is more than a cause of a lesser problem, of
  fluctuating, transitory poverty
• Risk may cause ex-ante and ex-post serious
  losses in terms of efficiency, growth and poverty
  reduction, since it may lead to poverty
  persistence and traps
• It is then much closer to the core of policies to
  reduce poverty and broad based growth
• A close parallel with the relevance of credit.

32
Outline

• Identifying the Problem?
• -Implications of Lack of Credit?
• -Implications of Risk
• 2. Why difficult to solve?
• The trouble with credit and insurance
• The experience with credit and insurance
• 3. What can we do about it?
• Credit
• Insurance
• Institutional models
• Evaluation

33
2.1 The trouble with insurance and credit

• General problems
• Informational asymmetries moral hazard and
  adverse selection
• enforcement problems.
• Specific problems in poor rural settings
• Risk in agriculture
• Costly monitoring and verification
• Institutional insecurity.

34
General problems with credit and insurance

• Enforcement problems because time features in
  contract (t, t1 for credit before and after
  state is known), parties may have incentives in
  t1 not to honour the deal
• Examples
• -insurance company may not pay out, or
• -borrower may not repay
• Implications loans too expensive and/or
  rationed, insurance too costly
• Solutions? Commitment devices rules, legal
  process, or incentives (making it in your
  interest to honour the deal)

35

• Moral Hazard after the contract, parties may
  change behaviour
• Examples
• -less effort by borrower (credit) or
• -less careful (credit and insurance)
• Implications loans too expensive and/or
  rationed, insurance too costly and/or rationed
• Solutions?
• -Monitoring devices, but costly
• -Incentive devices make contracts that make it
  worthwhile to put in effort or to be careful

36

• Adverse Selection before contract, lender or
  insurer does not know your behaviour, only the
  distribution of behaviour
• Examples
• -there are lazy and not so lazy people, or
• -there are risky agents or not so risky
  agents
• But lender or insurer does not know which type
  you are
• Implications loans too expensive and/or
  rationed, insurance too costly and/or rationed
  (good risks or hard working people are made
  to pay too much)
• Solutions?
• -Monitoring and information devices, but costly
• -Incentive devices make contracts that make it
  worthwhile to reveal your type so that you can be
  offered best contract (separate the good eggs
  from the bad eggs)

37
Specific problems with rural credit and insurance
in poor contexts

• Agriculture is characterised by high and
  covariate risk
• bad harvests happen for all farmers at same time
• bad harvests are really bad
• Bad for insurance provision (insurer needs to
  stockpile cash)
• Bad for credit provision (loan recovery with
  downward spikes)
• Implications
• Private credit and insurance provision is
  typically relatively low
• History suggests that spread is often linked to
  cooperative movements or imaginative interventions

38
Specific problems

• -Dispersed, poor communities, so costly
  monitoring (moral hazard), costly information
  gathering (adverse selection) costly verification
  (insurance).
• -Institutional insecurity
• -poorly functioning legal institutions
• -collateral could be commitment device, but poor
  property rights
• -legal proof of low harvest, or death
  certificates costly or unreliable

39
2.2 Experience with insurance and credit

• Credit?
• In some context, moneylenders local
  monopolies, exploiting high information and
  enforcements
• Informal credit (friends, relatives)
• High information and enforcement, but high
  covariate risks, so limited deepening or
  intermediation so limited use for agricultural
  credit
• few, if any private banks (or focused large
  farmers, rather different agents)

40
Credit

• Interventions?
• 1970s-80s, large credit programmes rural
  development banks, often state-run
• Poor repayment rates
• Problems with capture by political elites
• Source of patronages
• Ethiopia input credit
• Excellent repayment rates
• But at high cost!
• With harsh enforcement

41
Credit

• General Weaknesses
• few lessons learned from problems!
• Problems (information or enforcement covariate
  risk, institutions) are serious and there is no
  reason a priori that the government will be able
  to solve the problems that the markets face.
• market failure compounded by government failure

42
Insurance

• Crop insurance schemes
• Virtually no private schemes, beyond focused on
  large or contract farmers
• Public or mixed schemes
• Very costly verification (pre-harvest,
  post-harvest, moral hazard)
• Enforcement and adverse selection
• Highly political
• Highly costly
• In most economies, pure subsidy

43
Insurance

• Safety nets, relief schemes, FFW
• Poorly timed
• High cost
• Highly political (e.g. Sen)
• Concerns about targeting
• Are they insurance?
• -Non-enforceable contract (not credible), with
  political triggers
• -So benefits much less than insurance (ex-ante,
  people will still be forced to be inefficient)
• -only if guaranteed, with self-targeting (or
  illusive ex-ante credible targeting), equivalent
  to insurance.

44
Insurance

• Too few credible and effective insurance schemes
• Few lessons taken into account governments
  unlikely to solve easily all problems
• Market failure sometimes compounded by government
  failure

45
Outline

• Identifying the Problem?
• -Implications of Lack of Credit?
• -Implications of Risk
• 2. Why difficult to solve?
• The trouble with credit and insurance
• The experience with credit and insurance
• 3. What can we do about it?
• Credit
• Insurance
• Institutional models
• Evaluation

46
Stimulating credit?

• Learn from contract theory aligning incentives
  regarding information and enforcement
• Implement institutional development (regulation,
  rights, courts)
• Encourage market development (insurance, credit,
  information sharing, etc.)

47
Example micro-credit

• Small loans, often with intermediation of NGO
• Multiple models, many do not work very well in
  practice
• Two broad models
• Individual lending
• Group-based lending
• Brief discussion of how generic problems can be
  resolved in these models

48

• GROUPS-based schemes
• Individual collateral is being replaced by
  social collateral.
• Jointly liable for repayment or at least joint
  punishment for individual default which creates
  incentives to monitor (moral hazard).
• Encourage own group formation offering incentives
  regarding adverse selection
• e.g. offer two contracts, one with high joint
  liability and low interest, and one with low
  joint liability and high interest creates
  incentives for low risk households to join with
  other low risk households, but keep high risk
  households out revelation mechanism to separate
  good from bad eggs.
• Graduation (higher loans after repaying previous
  loans helps moral hazard plus enforcement).

49
Group-based schemes in practice

• Harsh enforcement by cutting off further lending
• OFTEN non-agricultural (avoids covariate risks)
• Often exclusion of the poorer groups
• Little or no insurance
• High interest rates
• High costs
• Still some real success stories (not just
  Grameen)

50
Individual lending schemes

• Individual lending
• Savings link
• High information environment
• Graduation of loans (building up individual
  credit histories)
• Also issues of exclusion, agricultural risks,
  high interest rates, costs, etc.
• Some success stories (e.g. Latin America)

51
Outline

• Identifying the Problem?
• -Implications of Lack of Credit?
• -Implications of Risk
• 2. Why difficult to solve?
• The trouble with credit and insurance
• The experience with credit and insurance
• 3. What can we do about it?
• Credit
• Insurance
• Institutional models
• Evaluation

52
Insurance

• Self-insurance (savings)
• Insurance
• From simple products (e.g. life insurance,
  rainfall insurance)
• To strengthening/building onto existing
  indigenous/informal risk-sharing arrangements
• Introduce insurance elements in programs
• Credible ex-post transfer system (guaranteed
  employment schemes)

53
Insurance against poverty

• Within a context of policies towards the poor
  that strengthen asset base and opportunities
• An additional focus on ex-ante strategies plus
  credible ex-post systems
• gt ways of insuring people so they do not need
  to go to extreme risk-avoidance, or be pushed
  into deep poverty if shock occurs

54
Examples

• Rainfall insurance
• Offering products to farmers in rain-fed
  agriculture, with transfer if rainfall measure at
  official station is below threshold (clear
  triggers)
• Limited monitoring, limited moral hazard, adverse
  selection, simple enforcement
• Avoids admin, time delays, political influence
• Same principle could be built in other support
  (e.g. micro-credit, aid delivery)

55
Examples

• WFP rainfall insurance for aid delivery for food
  aid/FFW distribution
• If Ethiopian average rainfall fall below
  trigger, Axo pays WFP particular sum,
  proportionate to aid requirement for intervention
• WFP (donors) pay Axo each year a premium
• Could be traded in secondary market for
  catastrophic risk
• Avoids aid delivery delays, political
  interference, etc.

56
Examples

• Asset transfer/creation schemes but with clear
  insurance element
• E.g. Conditional cash transfer as in Progresa no
  insurance
• Issue still is if shock large, children taken
  out of school, so human capital growth affected
• Could contain insurance element, whereby
  transfer increased if large covariate shock

57
Examples

• Agricultural credit e.g. Ethiopia
• Easy access credit for fertiliser (non
  collateralised)
• But harsh repayment enforcement
• and entirely uninsured
• Evidence that this results in those with low
  liquid asset base not daring to take on
  fertiliser
• Build in insurance element!

58
Examples

• Savings programs in microfinance
• Savings often means of building up credibility
  for lending
• But targeted flexible savings instruments for
  consumption smoothing/ food security, so provide
  specific encouragement

59
Examples

• Micro-insurance
• Deliver specific products to communities and
  individuals
• Take problems on board
• Health? Is difficult, but important
• Life-insurance some successful schemes (Latin
  America)

60
Institutional model

• Central agency, or government is at informational
  disadvantage
• So schemes that elicit incentives and information
  most effective (e.g. microcredit models)
• Not perfectly possible still information needs,
  which is costly
• But scale is important to spread risks of
  credit portfolio and pool risks for insurance
• Small is beautiful but costly
• High returns to reinsurance so formal economic
  agents at advantage (documented, verified)

61
Institutional model

• Delegated monitoring model
• Central (private/public) agency to exploit risk
  pooling/spreading incentives
• Contracted with local agent with informational or
  enforcement (cost) advantage (e.g. NGO or
  community based organization)
• Aligning of incentives between individual and
  local agent, and local agent and large company
  (bank, insurance company)

62
Evaluation

• There is no one microfinance (credit,
  insurance, safety net) model
• Do we really know what works?
• Need for structured evaluations (control groups,
  so controlled experiments), e.g. randomized.

63
Conclusion

• Risk and lack of credit as a cause of poverty
  means high return in economic, social and
  political terms to work on credit and insurance
  provision
• But difficult areas fraught with problems and
  bad experiences
• Time for more experimenting try out new ideas
  and evaluate.