Insurance: Security for Poor Farmers?

(Atul and Deepak Alok)

An assurance of a minimum guaranteed return should act as an incentive to the farmers to take to the new technologies, as the risk of such an adaptation would be covered. This should work out fine if the cost of insurance (i.e. money s well as effort) is small. However most of the dairy farmers in the country are quite poor and for them the premium turns out to be a significant portion of their savings. This makes it natural for them to expect some return on the premium paid.

There is also a limit to the level that the premium can be brought down to, as the risk to the Indian cattle is quite high. (Presently cattle kept under the best animal husbandry practices report a death rate of 2%). The shortcoming of the schemes presently in operation is that the premium payment is a one-time affair and the member gets nothing if he has not made any claim. For example to get a cover of Rs10000 on his cattle a member is required to pay a premium of Rs 400 at the beginning of the year.

In case the cattle survive through the year the member gets nothing back on the Rs 400 he has given initially. This is a disincentive for the member to provide necessary care to the cattle. In the absence of necessary care, the cattle productivity may come down; the insurance then becomes a means to cover deliberate and adverse risks, which the member then finds desirable. The whole purpose of productivity enhancement gets defeated.

Case Study in Mutual Insurance

(Deepak Alok and Atul)

Govindpura village is situated about 50 kilometers from Mehsana, in the Bijapur taluka of the Mehsana district. The Dairy Cooperative society in the village is unique in the sense that it has evolved its own cattle insurance scheme for its members. This is in a situation when the cattle insurance schemes in all the places are facing a lot of problems including that of high premium rates, moral hazards etc.

The scheme started on 15 th August 1996. Need for such a scheme came out of a crisis that the society faced about that time. It had a contract for the group insurance of the cattle of the members of the cooperative society. That year there was an unusually high death rate of the cattle in the village and the insurance company raised the premium rates. The society decided to sever its links with the company. The villagers sat together and decided to have their own fund to insure the cattle of the village.

In the first year 200 members joined the scheme with a contribution of Rs. 400 each. That year 7 cattle died and their owners were compensated each Rs. 8000 for the same. This resulted in a saving of Rs 47000 including interest. The cumulative savings in the funds have now become about 1.92 lakhs. The progress of the scheme is shown in Table 10.

The scheme is running with very simple rules and regulations. All the members have to contribute an agreed premium at the beginning of the year. Against this premium all their cattle are insured for Rs. 8000. However the claim will be restricted to only one cattle per year. Thus if a member has 3 cattle he will get Rs. 8000 on the death of any one of the cattle. Entry and exit from the scheme are voluntary. (Even non-members of the dairy cooperative society can avail of the scheme provided they are pouring a given quantity of the milk in the society.) If any body wants to opt out of the scheme, he will get his share of the net worth. If anybody wants to join the group he will have to contribute an amount equal to a member’s net worth. (For example at the end of the insurance year 1996-97 the total net worth of the society is Rs. 47000, or Rs. 235 per member. If somebody opts out of the scheme he will get Rs. 235 as his share. If somebody wants to join the scheme he will have to contribute Rs. 235 as his share in the net worth of the society.)

At the beginning of every insurance year (an insurance year runs from 15th August one Year to 14th August next Year) a survey of the households in the village is carried to determine a list of the insurable cattle in the village. Only the healthy animals are insured. The cattle, which are uninsurable, are tagged. Upon any reported death, a team is sent from the society to investigate if it was the insured cattle that died. Upon establishment of this the claim is settled immediately. This hardly takes two days of time.

Let us now consider how this arrangement has solved various problems related to insurance. First this system has a very low (almost negligible) transaction cost. There is no medical certificate. No paperwork, no post-mortem. Only thing that is maintained is a small register where the names of the owners of the cattle that are held uninsured are written along with their identification marks. There is another register where the total transactions for the year are recorded.

The premium rates here are very low as compared to the other schemes. For a 2.5% premium in the current year, you get all your healthy cattle insured. It cannot be a coincidence that the death rate of healthy animals is quite low in the village (17 deaths in five years out of about 900 cattle). This only points out to the fact that in other arrangements there is an adverse risk selection that many high risk and therefore uninsurable animals are also insured. Then there is also the problem of moral hazards in case of other animals when claims are made for cattle that were not insured in the first place.

Written rules of Govindpura Insurance Society

Period of the Insurance is for 1 Year.
Premium is to be paid yearly.
Amount of claim is Rs. 8000.
At the most only one animal death claim will be entertained, that is one claim per year per family.
Animal will be insured only after calving.
Members are free to take insurance from other companies.
In case of loss to the group every member has to contribute equally to meet the loss.


This system also checks moral hazard to a great extent. First there is a social watch on everybody that they do not underfeed their cattle, deliberately starving it to death to get the insurance amount. This is more likely to work in this mechanism, as people understand that if someone is unduly benefiting it is at the cost of everyone else. This reasoning is difficult to understand in the case of third party insurance.

This System could not have evolved after the negotiations with the insurance agencies failed, had there been no sufficient need perception for cattle insurance. This supports the argument that there has to be a felt need for the security provided by insurance (utility) for it to work.

This system draws a lot from the social capital that a society possesses. In a particular society higher is the social capital; higher are the chances that such an arrangement will succeed. Govindpura is homogenous in the sense that this is a small village all of whose residents belong to a single community. The socio economic status is also rather homogenous. This is not to say that this arrangement will not succeed in other villages where there are multiple castes and socio economic groups. If there is an adequate quantum of social capital this can be replicated in other places as well.


REPLICATION OF GOVINDPURA

The evolution of Govindpura is a result of the villagers’ own initiative. The scheme was readily accepted and its provisions and requirements quickly disseminated because the villagers had themselves been responsible for these. An external initiation of a similar model may face resistance, as the cost of formation of a new group would have to be overcome. Hence a proper selection of the villages where a similar model is to be externally initiated becomes important. Equally important is the agency that would initiate the scheme.

The selected villages should fulfill the following criteria in order to achieve a successful implementation.
The villages should be homogenous with respect to socio economic variables like caste and annual income.
Dairying should be central to the lives of the people.
The levels of human and animal death should not be too high.
The village should not have a history of conflicts.
The members of the selected village DCS should have some experience with Group insurance schemes of the Dairy Union.

The agency that takes the responsibility to initiate this model must have some experience in similar exercises. The CS/CD group that helps in the formation of the women self help groups has the expertise to take this responsibility as the activities to be undertaken in this case are similar and involve group formation. Once the villages have been selected he scheme can be initiated in the following manner.

Visit 1:This visit entails the following objectives:
Identification of the potential participants.
Informing these potential participants about the success of Govindpura.
Detailed outline of the scheme in Govindpuraa, its rules and provisions to be provided to them.
Target setting for the next visit/meeting, which must include a targeted group size.

Visit 2:The objectives are:
Enabling the group to express to security needs.
Enabling the group to decide its insurance needs.
Enabling the group in to evolving its own rules.
Selecting a committee from the group to clearly lay down these rules.
Target setting for the next visit.

Visit 3:The objectives are:
Discussion of the rules and modifications if suggested.
The necessary assistance in paper work
Facilitation of collection off the member’s contributions.
Announcement declaring the scheme open.

Thereafter follow-up visits are suggested to see whether the schemes are functioning smoothly. Adding some incentives (like capital infusion after a certain number of years) is also suggested.

The Vicious Cycle in Cattle Insurance Schemes

(By Atul and Deepak Alok)

Insurance paradox
For an insurance scheme to work the premium collected and the returns on it should be sufficient to settle claims that arise and to cover the expenses of operations. This would imply that the claim ratio should hover around one for sustainable insurance. The claim rates are high, particularly in the case of cattle insurance. There are also evidences to suggest that, paradoxically; the death rate is higher in the case of insured cattle. Our investigations also pointed out to the incidence of moral hazards (ie. not taking adequate care of the insured cattle) and adverse risk selection (ie. insuring unfit cattle). The insuring companies suspect cheating. The mechanism adopted by them to meet the cost of high claims is that of loading. In order to meet the cost of insurance (claim settlement and operational expenses) the insurance agencies increase the premium rates in proportion of the claim ratio.

Why take Insurance?
Most of the dairy farmers mention high premium rates as a reason for non-participation. Many of these farmers feel a definite need for insurance. The criterion for participating in insurance schemes at the society level is the surplus of the receipts due to claim settlements over the expenses due to premium payments (ie. the total premium paid by the members of the society). Such a criteria makes it difficult for the insurance companies to operate with a reasonable rate of premium. Higher claim ratio leads to loading and ever increasing premium rates. This results in a vicious cycle, which is described later.


Economic Rationality
From the point of economic rationality, a member would be ready to pay premium for an insurance instrument, without expecting any undue returns as long as his marginal utility for the safety provided by the instrument (ie the perceived benefits per incremental unit of premium paid) is greater than his marginal utility for money. The determinants for the former are primarily a) the member’s risk perception based on past experiences b) their own level of economic well being (affordability) and c) awareness about the presence of such an instrument. Once the marginal utility of the safety provided falls below the marginal utility for money spent on premium, the members start expecting returns and view insurance premium as a yield earning investment similar to securities. In fact we observed a high correlation between those who view insurance premium as investment along with safety and those who felt that the premium rate was high.

Role played by Dairy Cooperatives
There is a problem with the way insurance is seen at the society level. When the society is an intermediary between the members and the insurance company, it can clearly see the inflows and the outflows due to insurance. There is a possibility that the society will see this as another investment opportunity, the costs and benefits of which can be calculated on strictly monetary terms. Consider the case of a society, which has 1000 members who contribute Rs 100, each for the life of the members. This means an initial annual outflow of Rs100,000. If the premium rates had been calculated on strict actuarial principles, the amount received as claims will be around Rs100,000 during the year. There is also a possibility that the amount received will be less than Rs100, 000. The society may then feel that it would have been better off if it had kept the money with itself and compensated the members. This feeling may also tempt the societies to adopt fraudulent means to get a sufficient return on their “investment”.

The insurance agencies resort to loading when the claim ratio exceeds one. Thus the premium payable on a scheme increases. The question to be asked is that why did the claim ratio exceed one? Assuming that the initial premium rate was based on a good actuarial model that took into account all the inherent risks, it would seem that some irregularity was committed.

In the case of cattle insurance schemes running across the unions covered, only a few of the societies account for most of the deaths in the entire union. These societies are sporadically distributed in the region and did not record any epidemic. This points to some irregularity, some mechanism to get the maximum returns on the insurance premium paid. Obviously this requires a collusion of the members who participate, the doctors who certify and the authorities of the insurance agencies who monitor. The collusion between any two could result in the establishment of a fraud claim. This artificially inflates the claim ratio. As a result the premium rates increase. When this happens many of the members feel that the premium rates do not justify the real risks to their cattle. They then either pull out of the scheme or continue only if they are certain of returns (claims). Thus, there is an increase in adverse risk selection, and the upward spiral of the premium rates continue. Slowly most of the honest members drop out of the scheme and it degenerates. The scheme even when it is in operation fails to take care of the real insurance needs.

Interestingly, the perception at the society/union level is that while the members are their own, the insurance companies are the other party. Hence they usually condone some of the unscrupulous activities of the members. (In cattle insurance the union doctors limit their roles to identifying the correct animal and usually do not report if the death of the animal is due to negligence or bad Animal Husbandry practices). This precipitates the spiral - a vicious series of cycles, which lead to the failure of the schemes.

Rationale for Valuing Equity in MFIs

The microfinance sector is evolving from being predominantly grant driven to a stage where it is looking forward to attracting commercial capital. MFIs have been successfully utilizing commercial debt funds and are increasingly looking forward to commercial sources of equity.

In the past an MFI that achieved a Financial Self Sufficiency of 100% was assumed to have reached the epitome of sustainability. However, Financial Self Sufficiency may not necessarily mean commercial sustainability. In the most widely accepted definition of FSS, the cost put to equity is just the inflation rate, which we know is not true. The cost of equity depends on the risky-ness of the business the equity is invested in and will always exceed the inflation rate by an amount equal to atleast the risk-free rate. In effect FSS puts no real cost to equity.

Thus, there is a need to value equity investments in microfinance which puts a market cost to it. In the absence of market information, (as the sector is still in a nascent stage and MFI’s stock don’t trade except for a few MFIs in Latin America), it is natural for most investors to value an MFI based on its Book Value – utilizing a valuation range constructed from multiples of book value . Book value – variously called shareholder equity and net worth – is broadly defined as total assets minus total liabilities. This difference is the excess value a business has generated in its life. Book value is then multiplied by pre-determined coefficients to create the valuation range. However, the Book Value method may not be appropriate for valuing MFIs because of the following reasons:1) Backwards Looking Nature: Book value is sum of the total excess value generated by a business. Hence, book value measures only what a business has done, and does not necessarily have bearing on what it will do. In mature companies and industries, past history is often a strong indicator of future performance; in such situations, book value is an effective tool for determining a company’s present value. Microfinance, however, is not a mature industry, nor are many MFIs truly mature companies. Prior operating history is therefore not a good predictor for future results.

Historically, the microfinance industry operated along purely social lines. MFIs sourced operating funds from donors and philanthropic organizations in the form of grants, soft loans, and subsidized loans. These investments did not require profit maximization; at most, some investments required a nominal interest rate and future return of capital. MFIs utilized these funds as budgets, not as commercial equity investments; the firms did not have an incentive to build a surplus. Excess funds were generally utilized to explore new niches or to lower borrowing costs. Additionally, microfinance activities were often only one of many initiatives under an NGO’s umbrella. Excess profit generated through microfinance quickly flowed back into other parts of the NGO.

MFIs looking for commercial financing have refined their outlook to marry their social missions with the profit seeking ends of capitalism. Managing their businesses for profit while offering financial services to the poor and very poor allows MFIs to dramatically scale their businesses. Commercially financed MFIs will necessarily operate very differently than they have in the past; investments can no longer be viewed as budgets, and an entire class of investors will demand profit maximization. Examining their history of value creation – the premise behind a book value valuation approach – is a misleading method of determining an MFI’s value creation potential.

2) Lack of Comparables: Without commercial history in the microfinance sector comparables to assess potential MFI profitability and an MFI’s risk profile do not exist. Selecting the appropriate coefficients for book value is impossible in such an environment. Multiple coefficients for the book value approach are based upon two factors: one, the return to an investor a unit of book value will yield, and two, the return an investor expects from a particular investment. In practice, the amount of profit delivered per unit of book value (or sales or assets, or otherwise) is generally not known to any degree of specificity. This value is generally determined by examining multiples ascribed to similar companies or by examining a “standard” long term business model of a company or industry. Owing to its unique evolution and young age, microfinance sector does not have a set of comparable companies from which to draw from. A long term “standard” business model for the microfinance sector is also difficult to ascertain; at this stage, no one knows if a 2% return on assets, a 20% return on sales, or a 15% return on net portfolio outstanding is appropriate. Without either tool, determining the appropriate multiples is impossible.

The situation is further complicated by the differences between microfinance firms. Due to the youth of the industry, a plethora of models continues to persist. Each model has different operating profiles, different profit potentials, and carries different risks. Some key differences include:
Full Grameen model vs. Self Help Group – Grameen hybrid
Livelihood consulting vs. pure MFI
Full intermediation vs. service company operations
Significant regional variations
A multiple used to value one microfinance firm rarely transfers to another. Hence, even after a handful of MFIs successfully source investments in the near to medium term, selecting book value multiples based on comparables will be difficult. An effective approach must both be forward looking and function in a nascent industry. A valuation approach that meets these requirements is the discounted cash flow (DCF) valuation.

Using DCF in MFIs
Free Cash Flows are defined as cash flows that remain after we subtract from expected revenues any expected operating costs and the capital expenditures necessary to sustain, and hopefully improve, the cash flows. The Free Cash Flows to Equity (FCFE) represent the free cash available to the equity holder of the company and are good measure of the company’s capacity to pay dividends and provide capital gains opportunity to its equity investors. Discounted FCFE, is therefore, is appropriate way to value equity of a company which is in its initial life cycle stage, does not trade in public and so far has not paid dividends like most MFIs.

Peculiarities involved in valuing MFI’s equity
Financial services firms including MFIs have certain peculiarities, and therefore FCFE calculation has to be more measured and careful.

1.RegulationBanks and financial services firms are heavily regulated. In general, these regulations take three forms. First, banks are required to maintain capital ratios to ensure that they do not expand beyond their means and put their claimholders or depositors at risk. Second, financial service firms are a minimum level of Net Owned Funds or Net Worth. Third, entry of new firms into the business is often restricted by the regulatory authorities. From a valuation perspective, assumptions about growth are linked to assumptions about reinvestment. With financial service firms, these assumptions have to be scrutinized to ensure that they pass regulatory constraints, particularly relating to capital adequacy levels.2.ReinvestmentIf we define reinvestment as necessary for future growth, there are other problems associated with measuring reinvestment with financial service firms. Primarily, – net capital expenditures and working capital, could be considered as reinvestments required for growth. However, measuring either of these items at a financial service firm can be debated.Unlike manufacturing firms that invest in plant, equipment and other fixed assets, financial service firms invest primarily in intangible assets such as brand name and human capital. Not surprisingly, the statement of cash flows to a bank show little or no capital expenditures and correspondingly low depreciation. Similarly, if we define working capital as the different between current assets and current liabilities, a large proportion of a bank’s balance sheet would fall into one or the other of these categories. Changes in this number can be both large and volatile and may have no relationship to reinvestment for future growth. For example a bank may accrue a large interest cost on its deposits while the actual payouts on account of withdrawals are much less. The bank’s cashflow would in this case, gets artificially inflated.

Parishkaar, Hyderabad www.parishkaarindia.com

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