Microinsurance 101: How do poor deal with risk?

This is the third post in our Microfinance 101 blog series. The purpose of the series is to help non-practitioners and people in general who are interested in microfinance to understand various aspects of the field. This blog deals with microinsurance.

Microinsurance is a financial tool that helps poor households mitigate risk and plan for the future. It enables them to cope with unpredictable and irregular incomes, while also preparing them for financial emergencies that threaten their livelihood. One of the major problems faced by poor households is that due to low and unpredictable incomes, they lack a financial cushion. Living so close to the margin means that it doesn’t take much to push them over the line from poverty to destitution. When you live on less than $1 or $2 a day, an unexpected trip to the doctor or a bad harvest can quickly become a catastrophe.  Microinsurance offers a way for poor households to manage risk and deal with the ups and downs of life.

So why doesn’t everyone use microinsurance?

Despite the benefits of microinsurance, microfinance institutions (MFIs) have encountered significant challenges in the design and implementation of insurance products. Consequently, there are few sustainable and profitable microinsurance products available for poor and vulnerable populations.

One classic problem microinsurers face is an information asymmetry – that is they have limited information about potential clients to help them distinguish between those who want an insurance policy because they are prudent and those who want a policy because they are now likely to take more risks. A further complication is that the insured events of most policies (e.g. harvest yield or livestock health) are heavily dependent on the unseen efforts of insured individuals.

Other challenges to the success of microinsurance are specific to the population being insured. For example, there are generally lower literacy levels among poor households and less familiarity with how insurance works. Consequently, insurance providers need to do more to educate poor clients about the mechanisms and benefits of insurance. The reliability and reputation of the microinsurance provider is also crucial as there is a significant trust component inherent to offering insurance.

Insurance vs. Savings

A related question is: why the poor don’t just build up savings, which can be used for any emergency, instead of buying microinsurance, which covers only specific risks? 

Savings are often built up in small installments, but when emergencies arise they are unexpected and often require large lump sum payments (e.g. health shocks). Insurance payments for a particular emergency can help poor access a large amount of cash when they need it most, and although both savings and insurance can act as a safety net, insurance is immediately available while savings must be accumulated over time.