Q&A with Jim Roth

Jim Roth answers eight questions about long term contractual savings and the poor and the possible role that insurance companies play in providing these services.

Dr. Jim Roth

Q&A with Jim Roth

1. What are long term contractual savings?

In its simplest form a contractual saving scheme is a relationship between a client and deposit-taking institution, in which the client undertakes to regularly deposit an agreed amount for a set period of time. At the end of the period the clients can withdraw their funds, usually with interest. As the name implies, with long-term contractual savings the set period may be very long, often between 5 and 25 or more years.

2. Why are long-term contractual savings important?

For clients, perhaps the most common purpose for long-term contractual savings is old age pensions. Poor people often have frequent access to small amounts of money, but few ways to convert these into sums large enough to support them during the years when they are no longer able to secure a livelihood. Most developing countries do not have state pension schemes for the poor. Without retirement savings or other assets, the elderly must depend on friends, relatives, charity, or the state to survive. Other important uses of contractual savings include helping to generate sums large enough to cover the cost of marriages, funerals and education, in countries where these are expensive.

For MFIs, long-term contractual savings are particularly desirable because they provide a steady, predictable flow of deposits. The transaction costs of a well managed long-term contractual savings product are also typically lower than short-term savings products, making them potentially a very low-cost source of portfolio financing.

For economies as a whole, savings provide funds for investment. In developed countries long-term contractual savings in the form of private pension funds provide a huge part of total savings.

3. Do MFIs tend to offer long-term contractual savings?

Very rarely. One problem is regulatory. As long-term deposits often represent clients’ life savings, regulators are rightly concerned about efficiency, honesty and stability of the firms that hold them. They therefore tend to set very high regulatory hurdles, which MFIs are often unable to overcome.

Even where MFIs are licensed to mobilise deposits, few offer long-term contractual savings products. While there is undoubtedly huge demand for savings, a very high level of trust is required to induce clients to part with their savings for a period of, say, 25 years. Trust in financial institutions is often not high in countries that have witnessed currency collapse, mass bankruptcy of financial institutions, hyperinflation, coups d’etat, etc. Under these conditions it is hard for financial institutions to convince clients that their savings will be safe for a few decades to come.

While rare, some MFIs have begun to offer long term contractual savings. The Center for Agriculture and Rural Development Mutual Benefit Association (CARD MBA) in the Philippines has recently introduced a long-term contractual savings plan, which is compulsory for members. The scheme, known as the “provident fund,” involves members depositing PhP 5 per week (US$0.09). They receive 8% per annum on their savings and are able to withdraw their deposits when they reach sixty-five (the local retirement age). Non members who are clients of MFIs with whom CARD MBA has a relationship are also eligible to take part in the scheme.

In Poland, a number of credit unions have partnered with the TUW SKOK mutual insurance company to offer much shorter-term contractual savings plans linked with an innovative insurance policy called “Savings Completion Insurance”. Essentially, the product involves the credit union member deciding on a particular savings goal, and a time period to reach the goal (up to a maximum of ten years). The credit union then calculates how much the member would need to deposit each month to meet this goal along with an additional amount as an insurance premium. Should the member die before reaching his or her savings target the insurance company will pay the beneficiary the difference between the amount saved and the target.

BURO Tangail in Bangladesh developed a simple contractual savings account in 1997. This savings product involved a 5-year contractual savings agreement. The savings are deposited on a weekly or monthly schedule selected by the client. The scheme has proven immensely popular. In 2004, 70% of BURO’s customers voluntarily elected to open a contractual savings account. From 1997 to 2004, 205,860 long-term contractual savings accounts have been opened. Almost half that number have matured.

4. What other financial service providers could distribute these products to the poor?

In developed countries, insurance companies are one of the largest sellers of long-term contractual savings products. Insurance companies are often particularly well-placed to take savings because they operate on trust – the client has to trust that they will receive the benefit if they submit a genuine claim. The companies must also generally meet very demanding regulatory standards. In some countries (for example India) insurance companies must have over $20 million in capital to qualify for a license. Large regulated insurance companies possess greater institutional capacity than most MFIs and many small banks, and are typically more able to hedge long-term savings against inflation.

Endowment policies are a common long-term contractual savings product sold by insurers in many developed and a few developing countries. They involve a regular payment paid over a long term, usually more than 5 years. If the client survives the term they receive a lump sum. Should the client die before the expiry of the term their beneficiaries receive an insurance pay-out.

Insurance companies are increasingly interested in selling endowment policies to the poor, for four main reasons. The most obvious is that it can be profitable. Although the premium/savings amounts are small there is profit to be made if the transaction costs of collecting them can also be kept low. Secondly, selling endowment policies to the poor helps fulfil corporate social responsibility obligations, and endowment policies are a rare instance of a self-financing corporate social responsibility. Thirdly, insurance companies operating in new markets are keen get their brand into the market place. The thinking is that today’s low premium policy holder is tomorrow’s high premium client. Fourthly, in difficult markets where governments may be suspicious of private insurers (especially foreign insurers), insurance companies are keen to develop a good relationship with regulators and other government officials. Showing an interest in servicing low-income clients may help ease fears and facilitate entry into new markets.

5. What are surrender values?

If an endowment policy lapses – i.e. the client stops paying the premium – only a small part of the savings component of the policy is returned to the client. This is known as the surrender value. Only a small percentage of the client’s savings are returned because endowment policies are costly to design and manage. In addition agents tend to receive their commission for selling endowments in the first few years of the sale.

The surrender value creates much scope for mis-selling, often with tragic consequences for the client. In South Africa and a large percentage of the problems that come to community advice bureaus (advice centres for low income people) concern surrender values. A typical case involves a client who was sold a policy that was to mature when she retired. But for some reason she either retired early, was retrenched or her retirement age was miscalculated. The net result was that she received only a small surrender value, a tragic loss of most of her anticipated life savings. In many cases clients are not informed of the surrender value issue.

The most important remedy for such mis-selling is regulation. Regulators must ensure that clients are aware of surrender values, surrender values are fair, and that clients are informed if the return is not guaranteed. This may be a difficult task in many developing countries. For this reason, donors and development agents should only recommend endowment policies in countries where they can be effectively regulated. Poor after-sales service from agents can also be mitigated by examining the commission structure allowed by regulators, or through the use of “claw-backs” (in which insurers demand a return of commission from an agent if the policy lapses).

6. Would the poor be better off with term insurance and a long term contractual savings policy?

The short answer to this is yes. In an ideal world term life insurance tends to be cheap to provide and manage and with a stand alone safe long-term contractual savings policy there is no surrender value problem. Donors and other development agents should certainly work on multiple instruments to help ensure that the poor have long-term contractual savings.

The problem is that in the real world there are few safe long-term contractual savings instruments and a considerable demand for them among the poor. Few MFIs are able to mobilize any deposits, never mind long-term deposits. Even if they could, how many clients would be willing to entrust their life savings to them? Whatever their downside, endowment policies offer real long-term contractual savings with a relatively high degree of safety and sustainability.

7. How can transaction costs be kept down so that these products can be distributed sustainably?

Transaction costs can be kept down by partnering with agents who deal extensively with the poor. Such partners could include MFIs, NGOs, retailers, trade unions and religious organisations. For example, TATA-AIG, and Indian insurance company has recently begun to sell endowments directly to the poor through the establishment of micro-agents. These are agents who sell and service policies on a part time basis using a direct marketing methodology similar to that used by companies like Tupperware. For more information on this see the CGAP working Group paper on TATA-AIG.

That said, endowment policies, tend to be costly, both because they are sold individually rather than to groups, and because of their general complexity. Although some stripped-down versions are currently being sold to the poor, more product design research is required to examine where further costs can be cut. This is a potential role for donors, in partnership perhaps with the insurance industry.

8. What else can donors do to develop endowments for the poor?

Endowment policies present a significant new opportunity. The CGAP microinsurance donor working group has done excellent work in uncovering good and bad practice in microinsurance. This could be usefully extended to the design and management of endowments for the poor. Donors and other development agents can play a significant role in improving the design of endowment policies for the poor, helping regulators to regulate endowments and strengthen consumer protection mechanisms to ensure that the products are fairly designed and honestly sold.