53806 T I O N A L BA N NA K ER F T O IN R WORLD BANK T REC EN ON PM ST O RU L CT E VE ION AND D January 2004 No. 38 A regular series of notes highlighting recent lessons emerging from the operational and analytical program of the World Bank`s Latin America and Caribbean Region POOLING, SAVING, AND PREVENTION: A COMPREHENSIVE INSURANCE APPROACH TO SOCIAL RISK MANAGEMENT Truman Packard Individuals and societies can respond in a variety of ways This framework has four main implications: when faced with the prospect of economic losses from shocks like natural disasters, sickness, sudden death, disability and 1 Risk pooling and savings are substitutes: an increase in unemployment. Social risk management is a conceptual frame- the price of pooling increases the demand for saving. work encompassing three broad categories of response: pre- vention, mitigation, and coping. The Comprehensive Insur- 2 Risk pooling covers rare losses more efficiently than ance approach focuses on mitigation, offering a tool for deter- savings since the price of an efficient pooling instru- mining which insurance instru- ment should fall as the likeli- ments and preventive mea- hood of loss decreases, sures will be most effective while the implicit cost of given the size and frequency of saving does not change various types of possible eco- with the probability of the nomic losses.1 This article ex- loss. plains the comprehensive in- surance framework, and uses it 3 Pooling mechanisms do to assess recent reforms in not inevitably lead individu- Chile's unemployment insur- als to spend less on preven- ance system. tion. In theory, insured people might reduce their The comprehensive insurance safeguards against possible problem for individuals, house- loss; when you insure your holds, or governments is to de- house against burglary, for termine the optimal mix of "mar- instance, you may take less ket insurance", "self-insur- care to lock the house since ance", and "self-protection". Market insurance pools risks insurance coverage lowers the cost of replacing stolen across individuals. Where it is available, it can be purchased at goods. But this "moral hazard" is not inevitable. If pre- a price--the insurance premium. Self-insurance--essentially ventive measures reduce the possibility of losses occur- individual saving--does not involve risk pooling. While it has ring, and if reduced risk is rewarded through lower in- no explicit price, its cost can be imputed from the expense surance premiums, risk pooling and prevention can be- people incur to save, say in forgone consumption. Individuals come complementary. To illustrate, premiums for private without market or self-insurance must cope with whatever automobile accident insurance are typically higher for losses befall them. They can, however, mitigate risk through groups of drivers considered more risky (such as men self-protecting, that is, taking preventive measures. Preven- under 25 who own red sport cars). In some publicly pro- tion reduces the probability that losses will occur, but does not vided, "market-type" risk pooling such as unemploy- reduce the size of a loss should one occur. ment insurance in the United States premiums are risk- 1 rated -- US employers in industries with frequent turn- The Need for Public Intervention over pay higher unemployment insurance premiums than those with lower turnover.2 The comprehensive insurance framework goes beyond 4 Individuals are better off when all options are available. analyzing risk management at household level. It also offers If only pooling and prevention are available, individu- guidance for governments in examining the implications of als would be forced to use risk-pooling mechanisms for economic management and fiscal policy for social protection. losses that are not rare. If only pooling and savings are Governments have similar options to individuals and available, those who are good at prevention would be households facing risk. They can pool the risks of some denied the opportunity to reduce the premium they pay possible losses through promoting pooling (eg. private disaster for pooling. And if only saving and prevention are insurance or public standby facilities); they can save by available, individuals would be denied the most cost-ef- accumulating surpluses in good times to spend on social fective tool for protecting themselves against rare but programs during bad times (earmarking, stabilization funds, very costly losses. counter-cyclical spending policies); and they can help prevent losses by prudent monetary and fiscal policy, undertaking Figure 1 illustrates the prescriptions of the comprehensive reforms that increase factor market efficiency and safety, and insurance approach. It is more efficient for individuals to investing in increasing their administrative capacity. Often cope than to insure against small, rarely occurring losses governments that are forced to cope do so badly, cutting (top, left corner of the figure). As prospective losses investment in public education, health, and infrastructure. become more frequent, prevention and saving to mitigate losses become relatively more efficient. As prospective The policies governments use to manage risk affect the losses becomes less frequent but increase in size, risk instruments they can provide (or augment) for individuals and pooling is more efficient. For frequent catastrophic losses households. Governments that fail to prevent losses such as (bottom right corner), individuals or households can do unemployment by exercising prudent fiscal and monetary little on their own to mitigate the losses, and public policies and eliminating distortions in markets leave their citizens intervention is needed to provide larger risk pools. little alternative but to try to cope. That is partly because profligate public spending and failure to remove market inefficiencies increase the Figure 1 - Prescribed Mitigation Instrument According to Size and likelihood of macroeconomic shocks, Frequency of Potential Loss making them difficult to insure against, and partly because the same market Size of Loss Frequency of Loss (i.e. probability of occurrence) inefficiencies keep prices of saving and risk pooling from adjusting to reflect risks Rare Frequent accurately. do nothing more saving Small (coping) more prevention Where prices cannot adjust and administrative capacity to correctly price risk is low, the complementary link between Medium some saving more prevention prevention and risk pooling is broken, increasing the likelihood that social insurance will succumb to moral hazard and adverse selection.1 Governments that have sound economic policies reduce the likelihood of future shocks, thus reducing more pooling less saving the cost of pooling risks, and making social insurance more affordable. Large pooling prevention Unemployment Insurance Catastrophic pooling Because employment earnings are typically the largest source of household income, job loss and extended periods of unemployment can cause This usually takes the form of tax-financed social substantial, even catastrophic, losses. But where labor markets assistance, which in effect pools risks across all are relatively free of distortions and operate efficiently, the risk of taxpayers. Covariate risks--those suffered by many losses from extended periods of unemployment are usually rare individuals in the same potential risk pool at the same (although labor-market turnover may be high). In this happy time--fall in the catastrophic and frequent lower right situation, individuals are more likely to rely on savings to corner of the figure. mitigate income losses from relatively frequent turnover and 2 movement from one sector of employment to another, while privately managed individual savings accounts (similar to seeking other options to protect against relatively rare, but Chile's retirement savings accounts), and covered workers are larger losses from extended periods of unemployment. granted limited access to a government-financed pool of funds if they exhaust the balance in their accounts.2 The job of providing insurance usually falls to governments because the risk of becoming unemployed can be highly Seen through the comprehensive insurance lens, Chile's system systemic. When unemployment strikes, say in a recession, is well designed. It effectively mitigates the more frequent many individuals in the risk pool are affected at the same time. losses from job turnover (through savings) as well as the Since typically there are not enough employed people relatively rare losses from extended periods of unemployment ("winners") to compensate those who have lost their jobs (through public risk pooling). Although not necessarily ("losers"), it becomes too expensive for private insurers to considered by the designers of the new system, the cover losses. So unions and governments step in to provide combination of savings and pooling into a single structure is insurance instruments. These include pooling at the firm level in key, as it provides greater flexibility of parameters for policy- the form of severance programs, pooling across the working makers facing the changing nature of unemployment . Should population in pay-as-you-go unemployment insurance, and the magnitude or frequency of prospective losses from establishing systems based on individual savings accounts unemployment change with the economic cycle or changes in with minimum benefit guarantees backed by pooled funds. policy, the size of the savings component relative to the pooling component could be adjusted without requiring politically The Case of Chile contentious structural changes to the whole system. With recent notable exceptions, Drawbacks analysis suggests that Chile's labor market is relatively While considered highly efficient and free of barriers to innovative, the new system has employment (compared with drawbacks. First, the maximum Argentina or Colombia). As a potential benefit duration--five result, many individuals can months--is short, especially afford to self-insure against the with the rising average duration prospect of short-term of unemployment in recent unemployment, and the years. For the many unemployed government is well positioned workers who may not succeed in to provide pooling against finding work in that time, the end some amount of longer-term of their entitlement (as well as joblessness. Both forms of the fact that replacement rates protection increasingly appear decline with each successive to be needed: there is growing month) will result in hardship. concern that job loss is This problem will be especially becoming more frequent, and apparent during downturns the average duration of when the private labor market unemployment may be rising. Unemployment remains high--10 generates fewer new job openings than during periods of percent in 2001--and may be rooted in lower aggregate demand, growth. and in the realignment of relative prices. The cost of capital has been declining significantly, the cost of labor increasing. Since Second, the new system does nothing to protect workers in the 1998 minimum wages have increased about 20 percent in real informal sector against losses from unemployment. Previously, terms, affecting mostly small and medium-size enterprises, which informal and formal workers could qualify for benefits simply by are the major generators of employment in the private sector. offering proof of unemployment. By shifting to employer and Recent changes to the labor code may raise labor costs further worker contributions as the main source of financing, the through greater restrictions on employers in dealing with strikes system now draws a sharp distinction between the protection and dismissals. enjoyed by workers with legal contracts and those without them, including the self-employed. And the creation of Against this changing macroeconomic backdrop, Chile is individual accounts is unlikely to lead to greater formalization, gradually replacing a very modest, non-contributory as it did in Chile's 1981 pension reform. Then, individual unemployment benefit--the subsidio por cesantia, available to savings accounts replaced a pay-as-you-go payroll-tax all who can present proof of job loss, and financed out of financed system and actually led to a reduction in payroll tax general revenues--with a contributory unemployment rates. The new unemployment accounts do not replace a insurance system based primarily on private savings accounts. payroll-tax financed system and will add to payroll taxes rather The new system combines aspects of savings and market-type than reduce contribution rates. risk pooling. Employer and worker contributions accumulate in 3 All this suggests that Chile is missing an important instrument Latin America and Caribbean Region, World Bank, Washington to address the losses from unemployment. Self-targeting, D.C. 2003. For more on the comprehensive insurance approach, public employment programs ­ essentially, another form of see "Securing Our Future in a Global Economy" by David de publicly provided risk pooling that donot require formal proof Ferranti, Guillermo Perry, Indermit Gill, Luis Servén and others, of unemployment and that pay well below the private market Latin America and the Caribbean Region, World Bank, June wage) have been found to be the best "unemployment 2003, available at http://www.worldbank.org 2 insurance" governments can offer to informal sector workers, Risk pooling and prevention can only be complementary if the whether they have lost a non-contracted job, or their small price of pooling accurately reflects the probability of loss. Ad- business has failed in a recession. Although not explicitly ministrative and political reasons make this difficult to achieve, aiming to help such workers, noncontributory unemployment especially for large government social insurance schemes. The assistance and employment creation programs such as result is widespread moral hazard. Trabajar in Argentina3 may fit the bill because access to 3 Adverse selection arises from imperfect information. Since the benefits does not depend on whether workers have paid individuals most likely to purchase insurance are those more premiums or contributed to individual accounts. likely to need it, risk pools may include many bad risks­people more likely to suffer the shock and need a pay-out. Too many ********* bad risks in a pool means not enough good risks to cover pos- sible losses effectively. Notes 4 The new system became effective in May 2002, and applies to 1 Based on Isaac Ehrlich and Gary Becker, "Market Insurance, all new employment contracts. Workers with existing contracts Self-Insurance and Self-Protection," will have to join upon negotiating a new contract, and can Journal of Political Economy 80: 623­648 (1972); Indermit Gill choose to participate earlier. The noncontributory subsidio por and Nadeem Ilahi, "Economic Insecurity, Individual Behavior, cesantia will be phased out, and its current government funding and Social Policy" (Office of the Chief Economist, World Bank, will go to the pooled component of the new system 5 Latin America and the Caribbean Region, Washington DC, "Working in Partnership to Protect the Vulnerable," page 42. 2000). For an empirical application of the framework to the risk of poverty in old age see Truman Packard, "Pooling, Saving and About the Author Prevention: Mitigating Old Age Poverty in Chile", World Bank Policy Research Working Paper No. 2849, Washington, DC, and Truman Packard is a Senior Eonomist with the Social Protec- Indermit Gill, Truman Packard and Juan Yermo, "Keeping the tion cluster within the Human Development Department of Promise of Old Age Income Security in Latin America and the the Latin America and Caribbean Region, based in Washing- Caribbean" Conference Edition, Office of the Chief Economist, ton D.C. This regional focus takes us to the birthplace of social funds, Now Available! one of the first crisis-response tools forged in the social pro- Volatility, Risk, and Innovation: Social Protection in tection toolkit 15 years ago in Bolivia. What's more, it gives Latin an overview of how approaches to social protection have America and the Caribbean evolved in this diverse, dynamic region to include such tools SPectrum Fall 2003 as workfare, conditional cash transfers (which also had their genesis in the region), and multisector reform programs. This edition also explores new analytical approaches, describes new programs and emerging priorities, and grapples with the continuing challenge of finding effective ways to improve the capacity of individuals, households, and communities to manage risk. We believe social protection tools and strategies have a key role to play in reducing poverty and improving human devel- opment. They address the needs of vulnerable populations, generate tools for risk management through social insurance, and provide a springboard for poor people to improve their lives in the face of crisis. As important, the multisector, dy- namic nature of social protection allows for integrated ap- proaches to key areas of development, including health, edu- Download the new look SPectrum from http:// cation, finance, and infrastructure. Finding such synergies is www.worldbank.org/lacsocialprotection. This edition, the first crucial if we are to address extreme poverty and hunger, to have a regional focus takes us to Latin America and the achieve universal primary school completion, and tackle a Caribbean, where we examine the challenges posed by volatil- multitude of health challenges, all key elements of the Millen- ity and risk and explore innovative approaches to reducing nium Development Goals endorsed by the international com- vulnerability, particularly among the poor. munity in 2000. 4