THE DYNAMICS OF MICROINSURANCE DEMAND IN DEVELOPING COUNTRIES UNDER LIQUIDITY CONSTRAINTS AND INSURER DEFAULT RISK

• Author: Yanyan Liu,Robert J. Myers
• Date: 01 January 2016
• DOI: http://doi.org/10.1111/jori.12044
• Published date: 01 January 2016

THE DYNAMICS OF MICROINSURANCE DEMAND IN

DEVELOPING COUNTRIES UNDER LIQUIDITY CONSTRAINTS

AND INSURER DEFAULT RISK

Yanyan Liu

Robert J. Myers

ABSTRACT

We study the dynamics of microinsurance demand by risk-averse agents

who can borrow and lend subject to a liquidity constraint, and also perceive a

risk of insurer default. Liquidity constraints and perceived insurer default

both reduce the demand for insurance, possibly leading to nonparticipation.

We also evaluate an alternative insurance design that allows agents to delay

premium payment until the end of the insured period when income is

realized and indemnities are paid. We show this alternative design increases

insurance take-up by relaxing the liquidity constraint and ameliorating

concerns about insurer default. We also investigate the value of delayed

premium payment, and the importance of the associated problem of

reneging if the insured event does not occur, under a range of conditions.

INTRODUCTION

It is often argued that demand for microinsurance in developing countries is weak

because low-income households face liquidity constraints and lack trust in insurance

providers.

1

When premium payments are required, up-front savings or credit is

needed to buy insurance, so lack of access to credit markets can limit insurance

demand. Gine

´, Townsend, and Vickery (2008) find that liquidity constraints are an

important factor reducing insurance participation in rural India. Similarly, Cole et al.

Yanyan Liu is Research Fellow at the International Food Policy Research Institute (IFPRI). Liu

can be contacted via e-mail: y.liu@cgiar.org. Robert J. Myers is University Distinguished

Professor of Agricultural, Food, and Resource Economics at Michigan State University. Myers

can be contacted via e-mail: myersr@msu.edu. We would like to thank Chris Barrett, Glenn

Harrison, Ruth Hill, Miguel Robles, and seminar participants at Cornell University and Georgia

State University for their comments. We gratefully acknowledge the financial support from the

Innovation fund of IFPRI and the Microinsurance Innovation Facility of International Labor

Organization.

1

There are alternative definitions of microinsurance but our focus is on contracts with low

premiums and indemnities targeted to low-income individuals and households. These would

include life insurance, credit life, health, property, livestock, and crop loss coverage.

© 2014 The Journal of Risk and Insurance. 83, No. 1, 121–138 (2016).

DOI: 10.1111/jori.12044

121

(2013) show that providing Indian farmers with a cash transfer at the same time

insurance is offered greatly increases take-up. Low-income households with little

insurance experience also often express concern that once premiums have been paid,

insurers will default on indemnities when the insured event occurs. Perceptions

about this default risk have also been argued to limit insurance demand. Cole et al.

(2013) find that insurance policy endorsement from a trusted third party significantly

increases participation. A recent field experiment by Cai et al. (2009) confirms the

importance of trust in the insurer in the context of livestock insurance in China.

Liquidity constraints and perceived insurer default risk introduce explicitly dynamic

considerations into insurance decisions, but there have been few attempts to model

these phenomena formally in the context of dynamic optimization models. Gollier

(1994, 2003) and Braun and Koeniger (2007) develop dynamic models of insurance

demand that include liquidity constraints but not insurer default risk. The effect of

insurer default risk on insurance demand is studied by Doherty and Schlesinger

(1990) and Cummins and Mahul (2003) but only in a static setting and without

considering the role of liquidity constraints. Insurer default risk is also conceptually

similar to the study of insurance demand under background risk (see Eeckhoudt and

Kimball, 1992) and closely related to the study of optimal hedging behavior under

basis risk (see Doherty and Richter, 2002; Clarke, 2011). However, these issues have

been studied mainly in a static setting without considering the role of liquidity

constraints.

One goal of this article is to develop a dynamic model of demand for conventional

insurance, where premiums are required up front, in the presence of a liquidity

constraint and a perceived risk of insurer default. The motivation for the model is the

case of microinsurance, and particularly agricultural microinsurance, in developing

countries. However, the model is generally applicable to any insurance market where

up-front premiums, liquidity constraints, and/or default risk are prevalent. Three

initial results are derived. First, when there is no liquidity constraint and no risk of

insurer default, the usual result from static insurance theory that a risk-averse agent

will choose full coverage of actuarially fair insurance continues to hold. This result is

well known in the static insurance literature (e.g., Mossin, 1968; Smith, 1968) but for

completeness we illustrate that it also holds in our dynamic model. Second,

introducing a liquidity constraint reduces insurance demand in our dynamic model

because the up-front premium payment is particularly costly under these circum-

stances. Third, introducing a positive perceived probability of insurer default also

reduces insurance demand because up-front premium payments will be assumed lost

in the case of insurer default.

A second goal of the article is to analyze an alternative insurance design that increases

insurance demand by offsetting the liquidity constraint and ameliorating concerns

about insurer default. The alternative design allows agents to enter an insurance

contract while delaying premium payment (at the cost of an interest charge) until the

end of the insured period, after income has been realized. If they suffer the insured

loss insurers deduct the premium from the indemnity. If not the premium is still

required to be paid. The alternative design is found to ameliorate many of the

problems caused by liquidity constraints and insurer default risk, and thus has the

122 THE JOURNAL OF RISK AND INSURANCE