It is now well-accepted that the power of financial services to the customer, particularly low-income households, is realised only through the availability of a broad range of services, and not just through small loans or opening bank accounts. Financial inclusion advocates, therefore, describe access as necessarily implying a range of services, including payments, savings, investments, pensions, insurance and loans. However, the outreach of most financial services is abysmally low. There are over 3,000 mutual fund schemes in the market, but only four crore folios. Assuming liberally, that each individual has only one folio, this means less than 8 per cent of the population is using mutual funds to invest.
The Insurance Regulatory and Development Authority’s (IRDA’s) latest Annual Report indicates life insurance penetration at 4.6 per cent and general insurance penetration at 0.6 per cent. Majority of the people do not have bank accounts, and even though RBI mandates have ensured the opening of 50 million no-frills accounts, hardly 11 per cent are active. While the channel design contributes to low take-up and account dormancy, design of products plays a significant role in this.
PRODUCT OBJECTIVES
Financial products must be developed with the objective of helping households match their cash availability with consumption (savings, investments); manage uncertainty; and access capital for financing growth opportunities.
Financial services providers should ask: How can I help clients fulfil these functions of finance efficiently and continuously, using a range of financial products? If this indeed is the starting point, the provider must consider both demand-side and supply-side issues, for, while the former helps make the products more useful, the latter will ensure the institution’s sustainability.
DEMAND-SIDE ISSUES
From the client’s perspective, the key is usability of services, which is affected by how flexible, convenient, and reliable the product is for the function it has to fulfil. Though these are generic terms, they have local definitions because people’s experiences are different and they imply different things for different financial services. In the context of loan, flexibility means repayments are synchronised with household cash-flows. For a farmer, a loan with weekly repayments will not be an ideal proposition.
For insurance, the tests of convenience and flexibility lie primarily in the ability to provide claims settlement quickly and reliably. A personal accident insurance claim takes about a month to settle, especially where cashless settlement is not possible. The household, however, requires cash immediately to meet the medical/operation expenses. Rainfall insurance is a useful product, but the crucial design parameter is to have a rainfall measurement station close to the insured farmers’ location so that the basis for claim settlement is rainfall in the exact location.
Another overarching design requirement for low-income households is the ability to make frequent, low-value transactions — crucial for households with low and volatile incomes.
For product design, this implies the need to keep transaction-size barriers as low as possible by reducing cost of service delivery, primarily through effective use of technology. Demand-side insights are emerging from research in behavioural economics, which indicate the decision-making heuristics of clients, and how they understand convenience, flexibility and reliability. Designing suitable structures for savings and repayment can help clients comply much better than in the absence of such structures.
For example, there is significant improvement in usage of savings accounts if there is discipline in regularity of contributions. Similarly, there is value of simple interventions like reminders for a variety of customer behaviours, including loan repayments and insurance renewal.
SUPPLY-SIDE ISSUES
From provider’s perspective, the key concern is managing product risks. The primary source of this is information asymmetry between provider and customer. Information gap means that the provider has difficulty choosing the right clients for investing in, lending to or insuring (adverse selection), and once this is done, it cannot fully ensure that the client will repay (moral hazard). For example, health insurance may be sought by those likely to fall ill, and the insurer has limited ways of telling this with certitude. Product design must be clear about the customer circumstance so as to minimise adverse selection, and should price products accordingly.
Identification of livestock during claim settlement has traditionally been a source of moral hazard because of the insurers’ inability to identify the insured livestock during claim settlement. Technologies such as RFID (radio-frequency identification) help reduce this asymmetry. Difficulty in establishing causes of death has led customers to kill insured cattle to claim insurance amounts. Increasing risk participation of the customer may also help to align the interests of both parties.
There are systemic risks, like catastrophic events in specific geography, that the local lender or insurer cannot manage. This needs to be managed by trading these risks with larger, more diversified entities like reinsurers, or spreading them through markets.
Fulfilling functions of finance completely requires fairly complex financial designs, which are difficult for most customers to understand. It is the responsibility of the providers to convey the product features to clients in simple language, while managing the design complexity at the back-end.
The craft of product design lies in concealing underlying complexities, and conveying elegant solutions to clients, while taking responsibility for these solutions. This requires a deep understanding of clients’ needs as well as financial design. One without the other would be inadequate, even harmful.
This article first appeared in The Hindu Business Line
