Barriers to Household Risk Management: Evidence from India
Executive Summary — Insurance markets are growing rapidly in developing countries. Despite the promise of these markets, however, adoption to date has been relatively slow. Yet households often remain exposed to movements in local weather; regional house prices; prices of commodities like rice, heating oil, and gasoline; and local, regional, and national income fluctuations. In many cases, financial contracts simply do not exist to hedge these exposures, and when contracts do exist their use is not widespread. Why don't financial markets develop to help households hedge these risks? Why don't more households participate when formal markets are available? HBS professor Shawn Cole and coauthors attempt to shed light on these questions by studying participation in rural India in a rainfall risk-management product that provides a payoff based on monsoon rainfall. The results suggest that it may take a significant amount of time—and substantial marketing efforts—to increase adoption of risk-management tools at the household level. Key concepts include:
- To increase the insurance penetration rate of insurance products, it is important to minimize transaction and administrative costs and foster competition among insurance providers.
- Technological advances and contractual innovations may improve these products.
- The estimated significance of trust and vendor experience suggests that product diffusion through the population may be relatively slow until a track record is established. Optimal contract design could help by paying a positive return with sufficient frequency.
- "Catastrophe"-type insurance might be most beneficial for households, since it provides payouts that are concentrated in states of nature where the marginal utility of consumption is particularly high.
Financial engineering offers the potential to significantly reduce consumption fluctuations faced by individuals, households, and firms. Yet much of this promise remains unrealized. In this paper, we study the adoption of an innovative rainfall insurance product designed to compensate low-income Indian farmers in case of deficient rainfall during the primary monsoon season. We first document relatively low levels of adoption of this new risk management technology: only 5-10% of households purchase insurance, even though rainfall variability is overwhelmingly cited by households as the most important risk they face. We then conduct a series of randomized field experiments to test theoretical predictions of why adoption may be low. Insurance purchase is sensitive to price, with an estimated extensive price elasticity of demand between -0.66 and -0.88. Credit constraints, identified through the provision of random liquidity shocks, are a key barrier to participation, a result also consistent with household self-reports. Several experiments find an important role for trust in insurance participation. We find mixed evidence that subtle psychological manipulations affect purchase, and no evidence that modest amounts of financial education changes participation decisions. Based on our experimental results, we suggest preliminary lessons for improving the design of household risk management contracts. Keywords: Finance, Consumer Finance, Risk & Insurance, Development Economics, Field Experiments, Insurance. 59 pages.