> Posted by Sonja Kelly, CFI, and Thierry van Bastelaer, Abt Associates, American University, and the Microinsurance Network

Even 10 years ago, most of us would never have thought that the words “insurance” and “low-income households in the developing world” would be heard in the same sentence. It would have been as strange as, say, hearing the words “really good coffee” and “Washington, D.C.” in the same sentence.

But times have changed. Thanks to tremendous innovation in product design, pricing, and distribution systems, insurance is increasingly affordable to low-income households that are looking for ways to protect themselves from daily risky events. We should take a few moments to stop and celebrate this development. (Pause for celebration.) Thank you.

At the same time, we should learn from the history of the broader financial inclusion field. It took many years for the majority of the field to admit that credit alone can’t meet all the financial needs of poor families. Hopefully the excitement over insurance will not similarly delay the realization that it alone can’t address all the financial protection needs of these families. A great variety of financial products is needed to address an even greater diversity of needs.

So, over a cup of really good coffee one afternoon in Washington, D.C., we sketched out a possible framework that articulates where insurance fits into the product spectrum for financial risk protection vis-a-vis savings and loans.¹

We thought of risk protection expenses along two axes: frequency and size, and plotted expenses on a 2×2 table (forgive our back-of-the-napkin scribble).

Financially inclusive products are best designed to finance risk management expenses in the top left and bottom right quadrants of the graph. High-frequency inexpensive outlays can, when accumulating over time, significantly disrupt the cash flows of low-income families. Similarly, low-frequency expensive payments can ruin years of carefully planned asset accumulation. Low-frequency and inexpensive events (bottom left) can usually be covered by cash, and high-frequency expensive events (top right) are usually beyond the reach of most financial inclusion products.

Accordingly, we are left with a continuum of risk events, ranging from high-frequency/inexpensive events to low-frequency/expensive events, and we can map out the main classes of financial services along this continuum.

On the left side, savings are best suited to finance high-frequency, inexpensive events, since the effort and cost needed to save funds for such events is relatively low compared to borrowing or seeking insurance. For example, missing work for a day due to illness is an event that can be expected to occur fairly frequently and is relatively small when compared to the total monthly income. Loans are a less attractive option to finance such events, due to the generally high cost of credit in developing markets. Insurance is particularly badly suited to this type of event: as the cost of processing a claim is relatively independent from the size of that claim, high numbers of claims are very expensive for the underwriter—resulting in high premiums that are unaffordable for most low-income households. Outpatient care is a good example of this.

Loans, in the middle of the spectrum, are usually best suited for medium-frequency events of a relatively manageable size. They are not designed to finance risk events that are either too frequent or too expensive, and are better used for situations in which there is a predictable need for up-front expenditure that can be paid off over a period of time.

Insurance does particularly well at dealing with low-frequency expensive events, on the right-hand side of the spectrum. When faced with such events, low-income families have rarely saved enough to cover the entirety of the loss, while emergency loans—assuming they are available—usually carry an interest burden that creates dependency long into the future. Events such as a major long-term illness, the loss of livestock or property, an accidental death, or a natural disaster have financial implications that can rarely be met out of savings, and for which borrowing can be prohibitively expensive. It is for these types of events that insurance is most appropriate.

Of course, this assumes that savings, loans, and insurance are provided (and, preferably, regulated) in the environments in which vulnerable households live. And even where all three groups of services are available, there are some divergences to our neat classification. First, few financial services can, individually or in combination, provide full protection against risk. Partial protection is often the best that can be hoped for, but often that can be enough to prevent a devastating spiral of indebtedness, limited choices, and increased exposure to risk. Second, when the timing and financial impact of an event can be predicted relatively accurately, the ideal product mix can change. For example, when an expensive medical event is predictable both in terms of time and amount—such as the birth of a baby—correctly designed and supported commitment savings products can help set aside sufficient funds to cover the cost of the event. (See here for a study on an electronic savings product for maternity care in Kenya.)

Again, a variety of risks calls for a variety of financial products—affordable access to savings, loans, and insurance allows for a myriad of combinations to address very specific risks in very specific situations, and at the lowest possible cost. For example, hybrid risk management products that combine savings (best for high-frequency/inexpensive events) to pay for outpatient care, with insurance (best for low-frequency/expensive events) to pay for inpatient care, would result in more affordable protection than all-inclusive health insurance products. Creativity from, and collaboration between banks, MFIs, and insurers will be necessary to develop specialized saving, lending, and insurance products that dovetail nicely, and therefore complement each other for the benefit of all involved. (See here for a great overview of the role and value of 15 different insurance products in protecting vulnerable households.)

We are just starting to explore this framework, and we welcome your comments on it. Do you find it convincing and compelling as a way to approach financial inclusion beyond just the savings and loan dichotomy? Can you think of additional variations and divergences to it? If so, please feel free to share them with us here.

The opinions expressed in this post are solely those of the authors and do not reflect those of their employers.

Have you read?

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[1] We of course acknowledge the role of financial services for purposes such as income and consumption smoothing, and enterprise development, but we don’t address these here. We also recognize the role of remittances at the traditional fourth pillar of inclusive financial services but, as they come in all sizes and generally carry lower costs than loans and insurance do, remittances are not subject to the same trade-offs as those explored in this blog. For this reason also, remittances are, when available, almost always included in households’ risk management strategies in addition to savings, loans, and insurance.