Risk and uncertainties in life affect everyone. Most people, including the poor, use savings as a mechanism to deal with unexpected demands for resources caused by death, disability and illness. For poor people, however, saving for the unexpected can often mean severely containing consumption which often includes going hungry, undernourishment for children, and pulling children out of school and putting them to work to conserve resources. But even then, meagre savings that the poor do manage to accumulate are rarely enough and there is a need for insurance against such unfortunate events.
Many informal risk-sharing mechanisms evolve in societies to deal with risk and uncertainty. One such mechanism is the joint or extended family in which the resources and risks are shared. Risk-sharing is further enhanced by use of institutions such as the temple, the church, the mosque and the gurudwara, where people with means make a contribution and the needy members of the society obtain free food, medicine and other services in times of need. Various forms of safety nets, such as public unemployment insurance schemes, public health services and various public food distribution programs are further examples of risk-sharing mechanisms. A study by MIT Professor Robert Townsend indicates that the extent of risk-sharing, even in poor parts of the world, is not insignificant. So, the glass is not empty.
But the glass is only half full. The level of formal and informal insurance that exists, even in developed countries, is far from adequate. There are good reasons why risk-sharing, using both formal and informal mechanisms, is often inadequate. Formal mechanisms consisting of market insurance and use of financial contracts and derivatives to hedge risks are often infeasible for the poor. First, the transaction costs are too large. Second, the information problems are severe. Adverse selection -- when only the people who privately know that they are high risk choose to buy the insurance priced at a certain level -- and moral hazard -- when the insured people deliberately engage in high risk activities knowing that they are insured -- make formal insurance contracts infeasible.
Informal mechanisms are able to get around some of the problems caused by information asymmetries. Informal risk-sharing is often provided by people who know the insured well -- usually a family member. Moreover, since the contracts are informal and implicit, it eliminates the need for any paperwork or formal rules reducing transaction costs. Instead, moral and societal codes of conduct put a check on recalcitrant behavior.
But informal contracts don't provide adequate protection for many reasons. First, since informal contracts are only feasible among people who know each other relatively well, the reach of the risk-sharing is limited to a small number of people who are also likely to be poor and face many similar risks -- for example they generally live in the same geographic area. Ideally, risk-sharing should occur amongst peoples with uncorrelated risks -- for example people who are geographically apart. Attempts to achieve this are observed in practices such as marriages among families from distant villages. Nevertheless, informal mechanisms cannot confer benefits provided by formal insurance contracts which, in effect, can expand the risk-sharing neighbourhood to the entire world!
Integration of financial services demanded by the poor, micro-insurance, micro-savings and micro-lending, can reduce transaction costs and alleviate information asymmetries. Transaction costs are reduced because poor clients' needs for all their financial services can be taken care of under one roof. Moreover, when a client has a track record of, say regular savings, or a loan with regular repayments, some information is learnt about the client. This alleviates information problems making it feasible to offer other products such as micro-insurance.
Dr Nachiket Mor, former President of ICICI Foundation, argues that the KGFS model, with comprehensive financial services tailored and delivered in a branch by human experts, aided by modern technology and financial engineering models, provides a better solution to the problem of providing Financial Access to the poor than the branchless banking model that I wrote about in my blog. His worry is that branchless banking models still rely heavily on people and therefore cost savings are not as great as are often touted. So, if we are going to rely on humans anyway, he reasons, you may as well use them as efficiently as possible and exploit the flexibility and customization they can provide. My instinct is that if the branchless banking model could be scaled up dramatically, perhaps by integrating with Financial Access at Birth initiative, then the costs are likely to fall substantially and large masses of the poor that were excluded from formal financial services could first be included with basic financial services. A more comprehensive suite of financial services can then be provided in a KGFS type branch.