Bhagwan Chowdhry and S Anas Ahmed
The first noble truth, Gautam Buddha said, is “Life is suffering.” Trained as a financial economist, I translate this as “Risks are inherent in life.” But when I teach finance to my students, I point out to them that because “Risks can be shared” we can mitigate the suffering that uncertainties in life can bring. Sharing is the essence of what a family or community and indeed finance is about.
People have traditionally relied on informal mechanisms to protect themselves against the vicissitudes of nature. These informal mechanisms usually take the form of saving for the rainy day, transfers from family members less affected by adverse outcomes, charitable donations by more fortunate members of society, government relief aid in various forms (waiver of debt payments, free electricity, water and food for affected people etc).
At the level of the entire country or a state, relief may come from foreign aid and charity mobilised by relief organisations across the world. Even though such informal risk-sharing mechanisms are important in a civil society, they bring their own uncertainty, are not very reliable and are generally limited to a local area – international aid and support arrives only for extremely visible calamities. We should be able to do better than that.
This is what financial markets allow us to do. In the jargon of financial economics, many risks can be diversified. For example, many insurance products such as life insurance, automobile insurance, health insurance exist and are used by millions of people. But Robert Shiller, Nobel laureate in economics, has pointed out that there are many risks we face in life (unemployment risk, for example) against which the level of formal insurance (livelihood insurance) is woefully inadequate.
Furthermore, in a research paper by Shawn Cole, Xavier Gine, Jeremy Tobacman, Petia Topalova, Robert Townsend and James Vickery, they show, using evidence from India, that there are many barriers that have severely limited the use of formal insurance contracts. They suggest that many poor people don’t buy insurance because they face liquidity and credit constraints, do not trust formal insurance products and sometimes the advantages of insurance, such as large payouts in adverse situations, are not visible. Innovations by the private sector that address these barriers can increase the use of formal insurance products.
But we suggest a different solution. We propose a marriage of formal insurance contracts with informal insurance mechanisms. Large institutions, such as self-help groups, local banks and cooperatives, temples, churches, mosques, gurdwaras, even state and central governments can buy formal insurance against risks faced by people in the communities they serve – drought, floods, earthquakes, disease, negative shocks to local livelihoods etc.
The local institutions can then use their informal mechanisms – shelters, food langars, even cash disbursements – to help the people adversely affected in their area. They could even buy group insurance for their members’ protection against critical risks – which will be a lot cheaper than if individuals were to buy it on their own. This eliminates the need for (or supplements) the uncertain and unreliable aid that may or may not materialise when needed.
The paper by Cole et al suggested that the poor are very reluctant to make upfront payments for formal insurance products; they are so cash-constrained that they are willing to ignore the fact that if they are faced with an adversity against which they have not bought insurance, their situation would be very dire. A reluctance to pay upfront cash premiums is even prevalent in middle-class families who can, in fact, afford to buy insurance products.
On the other hand, people are often willing to help others when they are able to, by making charitable donations (recall the success of PM Cares fund during the pandemic), offerings to gods in temples, masjids, churches and gurdwaras. We suggest that institutions, when they receive such donations, should leverage these funds to buy formal insurance products, making the protection for their communities even stronger.
Markets work well at larger scales and at a distance. Informal mechanisms work well at smaller scales and locally where information and trust problems are resolved more effectively using social networks. An appropriate combination of the two would provide a more robust protection against risks in life.
Bhagwan Chowdhry is Executive Director, Digital Identity Research Initiative at ISB. S Anas Ahmed leads the financial inclusion vertical at DIRI
DISCLAIMER : Views expressed above are the author’s own.