Risk and Insurance - Ex-post and Ex-ante explained

There is ample evidence that poor households are vulnerable to shocks and often in developing countries, safety nets and credit markets tend to be inaccessible to them. Becker’s (1995) Household Production Model, sheds light on the behavior of households in developing countries where they often produce and consume what they produce, additionally deciding on the allocation of resources such as health, nutrition, labor and education. Often they fall prey to adversities such as crop diseases, labor shortages, policies affecting input prices. Though poverty and risk are bi-directional, this essay will begin with an analysis of how such agents manage risks, in context of ex post and ex ante, it will further move on to a critical evaluation of studies where we discuss households as a unitary versus collective model when dealing with risks, and concluding with policy recommendations and evaluations.

Azam (2009) illustrates that those without education or in agricultural households that are currently above the poverty line are highly vulnerable to poverty in the future. Therefore, it is necessary that such households engage in ex post risk management. Popularly, households can engage in formal or informal insurance. Informal insurance consists of cross-sectional risk pooling or social insurance. Formal insurance remains less popular amongst these households due to asymmetric information. The insurance firm may not be able to assess the vulnerability of such households, making premium calculations harder and more chances of default. Alternatively, informal insurance such as social insurance allows households to eliminate risks by dividing amongst their communities/societies. Platteau and Abraham, (1987) identify that households can in times of need can act as both debtors and creditors. Such arrangements of risk sharing approximate the Pareto-efficient allocation of risks. It maybe that community is well aware of the incidence of random shocks to households’ incomes, mitigating the problem of moral hazard and adverse selection that occurs from an outsider insurer.

Because poverty entails these households to risk and while overcoming poverty takes time, it is important that we understand what extent these risks are eliminated. Goldstein (2004) rejects that households act as single unit and also inefficient with respect to risk-sharing, thus rejecting a wide class of intra-household risk allocations. In his study of Ghana, women did not particularly receive assistance from non-family members during agricultural shock, but for illness while the case opposite for men. This potentially may expose women-headed households to poverty and agricultural risks. Townsend (1994) and Udry (1990) understand the issue of imperfect risk sharing in their studies and while this remains a desired medium, these households are poorly equipped to deal with covariant risks, such as weather shocks that can affect the community as a whole.

Households make consumption plans such that expected consumption is constant. Current consumption therefore is the annuity value of current assets plus the present value of the expected stream of future income. Rosenzweig (1988) provides evidence that rural households in India use transfers to smooth consumption, preferring this over formal credit. When such poor households face liquidity constraints, they may be unable to smooth their consumption due to inaccessibility in credit markets (Paxson 1992). Livelihoods spent in poverty neglect these households’ rights to acquire the necessary funds for instances of risks. Deaton (1991) identifies that without access to the credit market, these households may still be able to achieve consumption smoothing through reciprocity agreements such as using buffer stocks and on-farm practices such as inter cropping and cropping in different local micro-climates that inhibit the translation of weather risk to yield risk. The assets can be used to mediate the risk and smooth consumption. However, it is likely that the returns from these assets may be correlated; a bad year for crop yields is typically also a bad year in which to sell live stocks. This again translates to the assertion that poverty exposes these households to risks.

Suppose these households were to ensure risk management prior to its occurrence. Ex ante or the safety approach allow households to be involved in a variety of activities, including diversifying between farm and off-farm activities and also seasonal migration. Risk-coping strategies may also involve attempting to earn extra income when hardship occurs. Kosher (1995) reports increased labor supply as the key response in the ICRISAT villages. In a rebuttal, Carter et al 2007, identifies in Honduras and Ethiopia, consequence of poverty trap, households with livestock are less likely to sell them to cope with shocks, out of fear being unable to replenish their livestock holdings in the future. Hence, for such poverty stricken households, the use assets for consumption smoothing remains an opportunity cost.

Zimmerman and Carter (2003), show results that poor agents who are closer to subsistence minimum and therefore in danger of losing future labour power if consumption falls too low-pursue a more conservative investment strategy than do wealthier agents. The portfolios of poor agents are heavily invested in consumable assets (grain) which offer a lower return. The cost of this asset based risk coping, that is savings, in terms of forgone lucrative investment is high, about 18% of income. Study by Kuchler et al (2012) identify in rural Mozambique that this poverty stricken households may engage in child labour as a risk coping strategy. It is important that policies aim to understand the production and consumption patterns of such households and their exposure to risks. The Microcredit policy in Bangladesh has contributed largely in eliminating credit inaccessibility in Bangladesh amongst the poor. It follows the pattern of mutual insurance, helping to enhance employability, crop insurance and also price stabilization. A family born in poverty may continue to remain in poverty if the exposure to risk remains large and its consequences bounded by opportunity costs, gender biases and limited consumption smoothing.