March 29th, 2010

Sources of Micro Risk

Posted at 10:00 AM ET

Alex Bernhardt, Assistant Vice President
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Microfinance focuses on the execution of small, basic transactions in markets that do not have direct access to traditional financial services. While major institutions prefer to work with large amounts of capital, microfinanciers have moved in the other direction, making loans, issuing insurance polices, and facilitating currency transfers in parts of the world where individual transactions are not measured in billions or even millions of dollars, but in hundreds or single-digit multiples of ten.

Microinsurance, an emerging category of microfinance, works in a manner similar to traditional commercial insurance. However, products are designed for and distributed to low-income populations predominantly in emerging economies with historically low insurance penetration rates. This low-income population does not merely require smaller levels of risk protection compared to other socio-economic groups but also a distinct set of risk management tools and processes to enable appropriate financial access. These additional requirements are largely due to the unique risks which the poor face. While the precedents for mitigating these risks are few, various successful models are developing rapidly.

Risk management decisions are an integral part of everyday life, especially for individuals in the developed world. Before undergoing any potentially risky activities such as buying a home or driving a car, Americans are often required by a bank or a government to consider the implications of their actions and to protect against potential losses through the use of some form of risk financing mechanism, usually insurance. Such risk management decision-making processes are deeply ingrained in developed markets such as the United States, though the situation is much different in less developed countries. In these places the infrastructure and systems necessary to support adequate social or financial protections generally do not exist.

While a certain level of risk inheres in every human action, life in the developing world is generally much more risky than life in more developed countries. The reasons for this are many, but they relate primarily to the marginalization of low-income populations. By virtue of their circumstances, individuals at the bottom of the socioeconomic pyramid (BOP) are forced to live in riskier locations and to undertake riskier activities on a daily basis.

For example, BOP individuals tend predominantly to work in or around the agricultural sector or to provide manual labor to earn income. Such physically taxing jobs increase the vulnerability of workers and their families to death, ill-health or disability, which in turn increase their vulnerability to negative income fluctuations. Earning wages is difficult for those who cannot physically work. People who are impaired may find it difficult to collect benefits from government or from an employer (informal or otherwise). Social safeguards in emerging economies tend generally to be ineffective for the poor.

The focus of BOP labor on largely agrarian tasks also increases susceptibility to weather risks - such as drought, wind and flood - and economic fluctuations - such as rises and falls in commodity prices - by exposing the poor to many different types of loss simultaneously. The lack of an effective social safety net further leaves the poor helpless or reliant exclusively upon the assistance of philanthropic support that may be provided unreliably or with lack of consistency after the occurrence of a disastrous event.

Poverty very clearly increases vulnerability to risk. This risk, if left unmanaged or unmitigated, may reduce the ability of low-income persons to exit from poverty by increasing their microloan default potential and making poverty regression more likely.

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Risk and vulnerability create a cycle which undermines economic development and poverty reduction efforts. The poor have a basic lack of resources and an insufficient supply of useful, affordable and sustainable mechanisms to protect against or recover from loss. Historically the poor have managed risks in many reactive ways, though microinsurance stands to revolutionize the rapidly evolving field of micro risk management.

Click here to read Part I in the Microfinance series: What is Microfinance? »

Click here to read Part II in the Microfinance series: History of Microfinance »

Click here to read Part III in the Microfinance series: The Microfinance Market Today »

Click here to read additional material about Microfinance »

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