Incorporating Insurance Provisions in Microfinance Contracts: Learning from Visa?

This paper discusses the risk coping strategies employed by the poor to absorb income shocks, and suggests that these strategies ensure that the poor avoid profitable ventures in favor of less risky ones. The paper argues that repeated nature of microfinance contracts can allow lending institutions to set up insurance contracts through the creation of reputation mechanisms.

The paper suggests introducing an insurance contract that is tied to the individual loan by the financial institution. The insurance premium is based on the reputation and credibility of the client in paying loans on time. The paper suggests following precautions to avoid frauds and false claims:

• Decision to make a insurance claim by the client should be linked with reputation;
• Additional costs should be imposed in addition to reputation loss;
• Insurance premium and added cost imposed by financial institution should make insurance contract Nash Equilibrium.

The paper concludes with the following comments:

• Insurance is an important by-product of group lending contracts. However, in imperfect environment such as lending to poor, this contract entails a loss in efficiency;
• It is important to introduce simple credit with insurance contracts that financial institutions, having incomplete insurance mechanisms, can implement;
• Repayment insurance has the potential to encourage defaults; so this may be viewed as creative accounting by regulators or large scale risks.