Valuing Asset Insurance in the Presence of Poverty Traps

A growing literature of poverty traps advocates that social protection can be more effective in addressing poverty dynamics if it accounts for a critical threshold, around which both equilibrium outcomes and optimal behavior bifurcate. In this paper, we account for this type of threshold, and ask whether insurance can achieve the goals of social protection. Unlike traditional publicly-provided social protection, insurance is a market-based risk management tool that protects households only if they self-select into purchasing an insurance contract. To answer our question, we use stochastic dynamic programming methods to show that market-valued insurance uptake by vulnerable households holding assets near a critical threshold will be low, because the opportunity cost of insurance to them is particularly high. Paradoxically, these same households have the most to gain from protection of this kind. Because of the potential gains from insurance to vulnerable households, we analyze the benefits that can result from crowding-in additional insurance purchases by subsidizing insurance. We consider what these benefits mean for poverty dynamics in a typical setting by calibrating the model to the northern Kenyan rangelands, where evidence of a poverty trap exists and an existing insurance contract provides pastoralists the opportunity to insure livestock against drought losses. We find that providing insurance subsidies may be a more cost-effective way of altering poverty dynamics than traditional social protection policies. Our findings suggest that a public-private partnership between governments and insurance companies may be a useful avenue of social protection provision (JEL D91, G22, H24, O16). Sarah Janzen is a Ph.D. candidate in the Department of Agricultural and Resource Economics at the University of California, Davis. Michael Carter is a Professor in the Department of Agricultural and Resource Economics at the University of California, Davis. Munenobu Ikegami is a post-doctoral scientist at the International Livestock Research Institute in Nairobi, Kenya. We thank the BASIS Research Program on Poverty, Inequality and Development and UKaid (Department for International Development) for financial support. We also thank seminar participants at the 2012 AAEA Annual Meeting, the Pacific Development Conference 2012, the 7th International Microinsurance Conference and the I4 Technical Meeting 2011 for helpful comments. All errors are our own. Social protection has been widely heralded as an important policy tool to address persistent poverty. The aim of social protection is to enhance the capacity of poor and vulnerable persons to manage economic and social risks. Most often, this protection takes the form of food aid or cash transfers. In this paper, we focus on a particularly vulnerable subset of the population, and ask whether a market-based mechanism, insurance, can achieve the same goals as publicly-provided social protection. In order to be most effective, social protection must address poverty dynamics and the full range of factors that keep people in poverty (Barrientos, Hulme and Moore 2006). This requires a clear understanding of the structural foundations behind persistent poverty. The growing literature on poverty traps suggests that in certain environments there exists a critical asset threshold, sometimes referred to as the Micawber threshold, at which both equilibrium outcomes and optimal behavior bifurcate. In other words, two stable equilibria exist, a high (good) equilibrium, and a low (poor) equilibrium. These equilibria are separated by a third unstable equilibrium: the Micawber threshold. In this type of environment, uninsured risk and vulnerability play a key role because shocks can have permanent consequences. For example, if a shock causes a household’s assets to fall below the threshold, they move toward a permanent low equilibrium and find themselves “trapped” in poverty. For this reason, households holding assets near the threshold can be considered the most “vulnerable.” Barrett, Carter and Ikegami (forthcoming) account for this structural foundation of persistent poverty by modeling social protection provision in a setting of poverty traps, in which they explicitly model a dynamic asset threshold. They compare two strategies of providing social protection: one which targets the poorest households, and one which targets around the Micawber threshold. Their results suggest potentially large returns to targeting social protection assistance based on knowledge about critical asset thresholds. Although theoretically insightful, the main policy recommendations are practically and politically infeasible. For example, even if prioritizing the vulnerable poor (those near the Micawber threshold) offers dynamic benefits to the poorest as Barrett, Carter and Ikegami argue, it is difficult to justify using limited aid budgets on a policy which favors the vulnerable over those suffering from life-threatening food security. Moreover, critical asset thresholds are difficult to pinpoint, may vary across time and space, and may even depend on unobservable factors at the household level. Such imperfect information about thresholds means that distinguishing target populations remains a substantial hurdle. In this paper we recognize that publicly providing threshold-targeted social protection is practically and politically infeasible. Instead, we examine whether threshold-targeted protection can be achieved through a market-based risk management mechanism, insurance. Unlike publicly-provided protection, insurance requires that households self-select into purThe label ‘Micawber’ stems from Charles Dickens’ character Wilkens Micawber (in David Copperfield), who extolled the virtues of savings with his statement, “Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” Lipton (1993) first used the label to distinguish those who are wealthy enough to engage in virtuous cycles of savings and accumulation from those who are not. Zimmerman and Carter (2001) went on to apply to the label to describe the dynamic asset threshold for the type of poverty trap model we analyze here. Thus, the Micawber threshold divides those able to engage in a virtuous cycle of savings and accumulation, from those who cannot.