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Lecture 0527 - Lecture Index Insurance Business Today Index...

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Lecture – Index Insurance… 5/27/10 Business Today: Index Insurance o The logic of index insurance and an example of a research agenda o Reading: Poverty Traps and index based risk transfer products o Receive PS 4; due next Thurs in class Sections this week o Work through examples of key risk concepts o Bring a calculator Next Tuesday (June 1): Environment and Development o * “Can payments for o FINISH How does risk cause poverty traps? Avenue 1: Ex-Post asset reduction If I’m hit with a shock (drought, freeze, unemployment, etc) and don’t have insurance, I’m screwed I may lose assets (cattle die, land washed away, etc.) or I may need to sell assets => very difficult to build stocks back up (permanent physical capital reduction) o Ex: Mongolia livestock crisis I may have to pull kids out of school => very hard for kids to catch up (permanent human capital reduction). I may need to feed kids less => could have permanent cognitive implications (permanent human capital reduction). Avenue 2: ex-ante risk reduction actions To earn higher returns, I usually have to take on higher risk (grapes vs. corn) If I don’t have insurance and I’m risk averse, then I may decide to stick with the safe, but low return activity o This is a form of self-insurance (income smoothing) o It’s costly because I forego higher average earnings. If I do this year after year, it’s very hard to climb out of poverty. So ex-ante risk reduction actions can be very costly. Avenue 3: Negative spillover to credit market Demand side o Banks typically require borrowers to post land (or other major asset) as collateral. o If I don’t have insurance, I may not be willing to risk losing my land, EVEN THOUGH the project I could undertake is very profitable o So some people will voluntarily stay out of the credit market because credit contracts imply too much risk
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Supply side o Lenders, especially locally-based banks and micro-finance institutions, are not geographically diversified. o If a drought hits, then all farmers are likely to simultaneously default on their loans. o Thus banks restrict the size of their loan portfolio that goes to agriculture. o So some farmers are involuntarily shut out of the credit market. End Result o Missing insurance markets => credit markets are limited from both the demand and supply side. o Farmers unable (or unwilling) to get credit that would permit investment => poverty persists Why do insurance markets fail?
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