The following post is a part of a series that discusses 'managing risk for development,' the theme of the World Bank’s upcoming World Development Report 2014.To know more and share your feedback click here.
Who should be responsible for managing risk?
Sometimes those given the responsibility have the least capacity. People are generally capable of dealing with certain small risks. But they are inherently ill equipped to confront large idiosyncratic risks (household head falling ill), systemic risks that affect many people at the same time (natural disasters), or multiple risks occurring either simultaneously or sequentially (low harvest due to droughts followed by food insecurity due to a food price increase). To manage these different types of risks, people need support from other socioeconomic systems.
If the responsibility needs to be shared, who should share it?
Too often the first response to shared responsibility is to turn to the government for support. Government support, however, could require additional resources, possibly through increased taxes to ensure fiscal sustainability. Increased taxes could be burdensome for the economy and leave fewer resources for self-reliance (self-protection and self-insurance), which could be the most effective actions to manage some risks.
Moreover, government support can distort incentives, causing those affected by risk to take less responsibility for managing it (a situation known as moral hazard). For instance, some U.S. homeowners in disaster-prone areas do not buy disaster insurance knowing they can count on government aid if their home is destroyed. Hence approaches to sharing responsibility must ensure that risk takers or those exposed to risk retain some “skin in the game.”
At the same time, approaches to sharing responsibility need to draw on comparative advantages in risk management across the household, the community, the enterprise sector, and the financial system depending on the type of risk (systemic or idiosyncratic, small or large). Managing a given risk at the lowest level of aggregation that has the required capacity is a good principle to follow.
To share responsibility effectively, active cooperation between those affected by risk and those empowered to manage risk is thus crucial. Such cooperation can be achieved through efficient market mechanisms, regulation, or direct policy intervention.
Do individuals have the right incentives to do their share in active cooperation with other socioeconomic systems, including the state?
If people are to put their best effort into managing risks, markets and the society need to adequately value individual effort. A well-designed health insurance plan, for example, could reward and encourage healthy lifestyles. Or an individual’s unemployment benefits can be adjusted to reward intensive job search. In contrast, markets and societies that fail to reward individual risk management efforts may generate moral hazard.
The level of individual effort, however, must be observable to make the valuation of individual effort feasible. For example, driving is an individual effort that falls into the category of self-protection against risk. But because the way one drives is hard to observe, insurers have not fully recognized it when setting individual car insurance premiums. In this case, the use of the use of new technology known as telematics could rapidly change the status quo. Telematics technology enables insurers to tally how often brakes are slammed or corners taken on two wheels. Some telematics devices include location tracking options that can monitor whether a car is exceeding the speed limit. Insurers in Britain and Italy are leaders in this field, employing telematics to charge drivers an insurance premium based on “pay-as-you-drive.”
Can individual effort also help mitigate systemic risk?
Just as idiosyncratic risks must be pooled with pricing consideration given to individual effort to manage risk, contributions of individuals and socioeconomic systems to systemic risk must be internalized to make sharing responsibility for managing systemic risk effective. People’s contribution to systemic risk may be intentional, as a result of moral hazard or free rider problems, or be unintentional, where coordination failures exist or risk management actions at the individual level lead to negative externalities that create systemic risk.
Too often, individuals who take higher risks bear only a small part of the incremental costs resulting from their decision. Consider, for example, the many individuals in the United States and Europe who borrowed excessively in the pre-2008 credit boom; few of them considered that the cumulative effect of their individual overindebtedness and financial fragility could threaten the stability of the whole financial system. The same is true of the lending institutions who themselves contributed to the growth of systemic risk by lowering lending standards or engaging in predatory lending practices.
Likewise people and firms do not have incentives to individually respond to long-term, systemic risks that have limited short-term consequences, such as carbon emissions or depletion of water resources. In contrast, other individual activities, such as technological innovation, could produce positive externalities that benefit the whole economy not only through aggregate growth but also through flexibility in absorbing shock and continuously providing new employment opportunities.
It is thus important that negative externalities be internalized and the positive ones rewarded through appropriately designed public policy. A carbon tax reform that is distributionally and revenue neutral can be more efficient in slowing global warming than quantity-oriented mechanisms and can also address concerns such as the negative impact of carbon pricing on low-income households. To amplify positive externalities of technological innovation, countries could learn from India's public-private partnership programs for early-stage and viability-gap funding that have produced the first indigenously developed oral vaccine to prevent high infant mortality from rotavirus-caused diarrhea.
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- WDR 2014