The derivatives contract in slum housing!

Slumania is a squatter slum in the Urbania Municipality of Corruptionland. It houses nearly 500 families in 3 acres of government land. Like other such slums, it has all the features of un-planned growth - small and irregular lanes, no side drains and sewerage network, leaking water lines, unhygienic surroundings etc. The election promise of Aya Ram, the local MLA, was to get a multi-storied housing colony sanctioned with roads, water and sewerage lines.

Finally, thanks to the his efforts, as part of the National Urban Development Mission (NUDM), the Government have sanctioned multi-storied (G+3) housing units with all infrastructure facilities. The Urban Community Development wing of Urbania Municipality does the Socio-Economic Survey (SES) to document the list of beneficiaries. Possession Certificates (PCs) of all beneficiaries are prepared and kept ready for distribution.

Simultaneously, Aya Ram's cronies swing into action. They demand that Rs 10000 be paid by each household to ensure registration. This is despite their name already having been cleared in the SES conducted by the Municipal authorities. Now, Rs 10,000 is not a small amount for the beneficiaries. Most of them already face an uphill struggle to pay the Rs 10000-20000 beneficiary contribution required to get the house sanctioned. Despite this, they immediately pay Aya Ram's extortionary tribute.

Why do people pay the premium despite their name finding place in the SES list and the assurance of a formal government mandate, the PC? This requires an examination of the post-sanction risks faced by the PC holder. After the sanction, the processes of tender finalization and completion of work, would take atleast 12-18 months. Even the process of physical allotment has numerous uncertainties associated. This is a long enough window for several risks to surface - the local muscleman may arm-twist the beneficiary off his PC, Aya Ram's cronies may collude with officials to issue duplicate certificates on the same house (thereby robbing the beneficiary off his allotted house), and so on. So here is the economic rationale behind the exorbitant premium,

1. The premium is a hedge against these risks. It is the cost of buying protection against these uncertainties. The contract is a form of derivative - beneficiary being the protection buyer, Aya Ram the protection seller, and protection against dispossession is the risk being purchased! The payment made to Aya Ram's cronies is proportional to the perceived risks to obtaining final possession of the house. In many respects, it is the simplest of insurance contracts.

2. The willingness of the beneficiaries to pay an exorbitant premium, despite possessing a government issued and legally valid certificate (the PC), is a reflection of the credibility deficit of government contracts. In other words, the premium is a measure of the cost of the contract (even government ones) enforcement in such environments. Higher the premiums, greater the institutional credibility deficit or weaker the contract enforcement conditions.

Ricardian equivalence in insurance

Ricardian equivalence refers to the argument that consumers internalize the government's borrowings by cutting back on their spending (or increasing their savings) in anticipation of higher taxes in future. Conservative economists have invoked this to argue that government deficit spending cannot stimulate aggregate demand.

The NYT has an article raising the issues concerning insurance industry in the aftermath of the Japanese earthquake and tsunami,

"Moody’s said ratings for all of the major reinsurers were stable, and many reinsurance analysts said they saw one bright spot in the disaster: prices for reinsurance have been declining for several years, and while the earthquake will hurt the results of companies for one quarter, it might spur new demand and higher prices.

Reinsurance contracts are often renewed in April, and Keefe, Bruyette & Woods issued a report on Tuesday suggesting that losses from the earthquakes in Japan and, recently, New Zealand would lead to firmer prices on California earthquake and Florida hurricane insurance."

This is classic rational expectations (or cognitive biases) operating from both ends of the market. Property owners, atleast in earthquake prone and coastal areas, swayed by the availability bias generated by events in Japan, will be more inclined to insure their assets in a more comprehensive manner. Similarly, insurers would increase the actuarial risks associated with such events and price their premiums upwards.

Assuming that the actual risks remain the same (taken on a historic scale), the insurer can therefore hope to claim higher profits in future (though this is partly reduced the higher premiums that re-insurers are themselves likely to charge). To this extent, insurers will be able to recover a large portion of the current payouts from these higher future premiums. This begs the accounting question about what is the real long-term impact of such earthquakes on the insurance industry.