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Interview with Lorenzo Casaburi and Walter Kielholz
How do the risks and the demand for insurance differ between developed and developing countries?
Walter Kielholz: First, we need to clarify what people mean when they talk about risk. Natural disasters i.e. bad weather, flooding, draughts are the same across the globe. However, the consequences can differ enormously between highly developed and structurally weak regions. What does differ is the risk you have as an individual, the pain and hardship associated with losing your assets.
There is a strong correlation between accumulation of wealth and the demand for insurance. If you don’t know how you will feed yourself tomorrow, insurance is not on your mind. With increasing wealth and assets, there comes a point where people have a relatively safe job and a few assets, a car or a small house. It is in this area of the ‘early middle-class’, where the demand for insurance rises significantly. People are afraid to lose their health, income and assets and want to insure against such loss.
Lorenzo Casaburi: This S-shaped demand curve for insurance, with little demand for low incomes and a strongly increasing demand in the middle, applies to individuals as well as firms and countries as a whole. The issue we see in many developing countries is the missing middle. We have a plethora of very small firms (often one-person firms), a few large firms, and not much in the middle. So, the majority of individuals and firms are below the threshold where they’d consider or are able to get insurance.
What are the specific challenges the insurance business faces in developing countries?
KIELHOLZ: One of the biggest challenges for insurance in developing countries, and even in some developed countries, are the high transaction costs. Compared to the amount at stake, the cost of handling the contract and assessing the claims is very high. In addition, insurance markets in developing countries are overly intermediated. There often are numerous middlemen all taking their cut, without adding any value.
CASABURI: I agree, middlemen are often an issue. However, in some cases, working with intermediaries can reduce transaction costs. Many farmers in developing countries are part of a cooperative. Working with such cooperatives drastically reduce the transaction costs for insurances. They deal with one cooperative, or one middleman, instead of 10’000 individual farmers.
A major aspect that is often overlooked is trust. It is not uncommon for intermediaries not to pay out, or for the managers of such cooperatives to run away with the money. There is a deep-rooted mistrust. Trust is essential for economic growth. You need to be able to trust your business partner, and trust that contracts can be legally enforced.
KIELHOLZ: And sometimes, simple logistics can be a hurdle: how do we get the 50 Dollars to the person in rural Pakistan without incurring fees that are a multiple of the payout itself.
How can these difficulties be overcome?
CASABURI: Trust, for example needs to grow over time. We know that if insurance companies in a village start paying out and the community sees these insurance payouts being made, the people are more likely to request insurance. It is often the small things that have a large impact. One piece of research I did was on the timing of insurance payments. Usually insurance premiums need to be paid at planting time. However, few farmers have extra cash when they need to buy their seeds. If you allow them to pay the insurance premium during harvest time, when their income is highest, the take-up rates are much higher. We saw an increase from 5% to 72%, and even higher for the poorest farmers. This is an enormous surge and makes all the difference for the security of farmers’ income.
KIELHOLZ: One way to reduce the verification costs is to define parametric and binary payouts. For example, an area has 100 rainy days per year. If one year we only count 20 rainy days, farmers get an insurance payout, even if some of them may have had a normal yield. It is cheaper to have such binary payouts than assessing individual claims.
Mobile phones have allowed us to make significant progress in settling claims and allocating money to individuals without incurring high costs. That is a huge improvement. There are also efforts to be able to earmark such mobile insurance payments just for the use for seeds.
CASABURI: We are currently also evaluating ways to reduce the costs of claim verification. Together with the Swiss Re Foundation, we are piloting community-based verification of health insurance claims e.g. if somebody really was in a hospital or health facility. We use existing community groups, e.g. joint savings groups. If one of the members of this group files a claim to the health insurance, other members have to confirm this claim. If this group level of verification can provide good quality of verification while also mitigating the cost verifying each single claim, this would be a huge simplifier and allow massive cost reduction. Some of the most interesting work on promoting insurance in developing countries is by connecting formal insurance products with informal community networks.
KIELHOLZ: This might sound foreign to us today, but not so long ago we used similar, local knowledge based verifications in Switzerland with the «Ortskrankenkassen». These were small local health insurers. You paid your premiums and claimed your costs. Nobody would go and claim for something that everybody in the community knew wasn’t true. Obviously, the solution had major flaws concerning data protection, and the fact that one person verified all the local claims. But, the idea was the same, claims were verified by people who knew the people who made the claims.
What is the impact of natural disasters on economic growth, especially in developing countries?
CASABURI: The point on natural disasters hindering economic growth is a very important point. I do a lot of research in sub-Saharan Africa where farming is the most important sector. In these regions, agriculture is mostly rain-fed. There aren’t many irrigation systems. This means that a given national event like a draught has very severe consequences as these farmers don’t have an irrigation system that could at least partially make up for the lack of water.
You also need to consider the wider economic and social ecosystem. Imagine a farmer experiences a draught which destroys most of his harvest. If he is not insured against such an event, he will need to find a way to mitigate this loss of income. Either by dipping into his savings or by taking on credit. However, if he has no savings and no access to credit, then this production shock is going to translate into an even larger consumption shock. People in poorer countries are less likely to have access to other financial markets, so the negative effect on consumption and the total welfare consequences of a given risk are the largest for the poorest of the poor.
KIELHOLZ: The effects of natural disasters and economic growth probably works in both ways. An increased propensity to natural disasters can hamper economic development. A country which is regularly destroyed by earthquakes or volcanic disruptions will have difficulty to accumulate assets, e.g. basic infrastructure and networks. This could also be a reason for slow development. The ability to respond to natural disaster is crucial for economic development.
How do countries differ in their ability to cope with risks and natural disasters?
KIELHOLZ: Infrastructure, physical or institutional, is key. Compare the earthquakes we had in 2010 in Chile and in Haiti. Haiti did not have much of an insurance infrastructure or a ways to settle claims. While a lot of aid money was raised, not much trickled through to the ground and into projects to rebuild. Chile on the other hand is a highly insured market with established settlement processes. In the case of Chile, the earthquake promoted economic development because the money came quickly, workers could be paid, and the damages could be repaired. The disaster was actually a promoter of economic growth. The differences between these two countries were so obvious that the World Bank started a study about the economic effects of natural disasters to understand these drivers.
CASABURI: These are very complex discussions, and each region or country is different. It depends on how the political class responds, how entrepreneurs respond, the existence of these settlement processes and the strength of the government. The response to natural disasters is a very good example of the power of good public-private partnerships. You can’t leave it entirely to the private sector to carry all the risks in the case of natural disasters and to coordinate the rebuilding efforts. And, you can’t expect government organizations to handle individual settlement claims. Both sectors must have established infrastructures that complement one another.
Looking at the current pandemic. What can we consider and learn for the future?
KIELHOLZ: Pandemics are a problem of global accumulation. Within a month, the problem is everywhere and hits everyone. There is no economic system, private or state, that can deal with that. As insurers, we diversify risks by underwriting other, similar risks in a portfolio. We can’t do that in the case of pandemics. However, we could diversify pandemic risks over time. Let’s assume that such a global pandemic occurs every 25 years. Then we can spread the costs. Everybody contributes with 1 or 2 percent of the claim. Over time, we accrue the funds. There’d need to be a backstop by the government, a guarantee to fund the difference. This would be a self-funding mechanism, a kind of pandemic pool, and a number of countries around the world are currently considering the idea.
CASABURI: This response could work well in more industrialized countries. Richer countries are much more responsive in getting into partnerships with governments and getting governments to commit to backstop funding, they have access to financial markets etc. Therefore, although it definitely helps, it may also further increase the gap in coverage between richer and poorer countries.
Our students would like to know what Economists at Swiss Re do…
KIELHOLZ: A good friend of mine once said that Swiss Re is a university with a balance sheet attached. He wasn’t completely wrong. Financial service providers including Swiss Re as a re-insurance company, do a lot of research in the area of financial markets and risk management.
For basic research, we rely on academia. That’s where unbiased, broadminded and open research happens. As part of our product development we do a lot of concrete and applied research. Concrete financial interests drive this research. Then there is this area in between, e.g. modelling certain risks in the insurance sector. We try do as much as we can inhouse as part of our value proposition.
CASABURI: A lot of work we do is to come up with a hypothesis, test a theory and then do a proof of concept. So we try to answer questions such as ‘what influences trust in an insurance provider’, or ‘does pressure from your relatives form back home affect your financial decisions’ etc. and then we test whether the hypothesis is correct or not. Bringing such insights into a commercial product happens outside the university.
KIELHOLZ: Insights from basic research are crucial to our business. The mental models based on insights from experimental and behavioral economics really helps in developing good products. We are strong in analytical skills, but insights from behavioral is key to create the right models to understand human behavior, to ask the right questions.
