Sharing the burden: Criteria for risk allocation

Sharing the burden: Criteria for risk allocation

The restrictions imposed to contain the spread of COVID-19 are causing major economic disruption. Governments have quickly put in place measures to help manage the impact of the disease and protect those who are hardest hit.

But there is huge uncertainty about how the pandemic will develop and how deep the economic shock will be. Who should bear the risks of this uncertainty – investors, creditors, taxpayers? - is a difficult question that policymakers will need to answer. We wrote last week about the nature of these risks and the choices for policymakers. In the second in our series, we discuss some of the economic criteria that can be used to provide an answer.

How should the economic risks of COVID be shared?

Businesses are used to facing uncertainty over costs – from employee accidents to a decline in demand for their core products. These risks are borne by their insurers, owners, investors and creditors, who, if the worst comes to the worst, must meet the cost of unforeseen events. But in exceptional crises, policymakers can choose to assume the responsibility, or act to change who holds these risks in the wider economy. We described these choices in our previous article.

The economics of who should bear the risk hinge on four critical questions, which we illustrate below.

Fairness

Most people would accept that it is fair and reasonable that the risk-taker should be the one to bear the risk. An investor who puts money into a new business will win or lose depending on whether its product finds a market. A firm that chooses to reduce its inventory to cut costs today bears the risk of supply chain interruption tomorrow.

This principle of fairness and causality applies best to individual or business-as-usual risks. It cannot apply when the risk is something beyond anyone’s control. In that case, other concepts of fairness may come into play. The standard approach in these situations is to socialise the risk: have the state assume the risk and cover the cost through its usual revenue-raising mechanisms. This is how most healthcare systems in the developed world operate.

Affordability

It is not feasible in the long term for a state to assume the full cost of a pandemic, so a concept of fairness based on need may be helpful: those who can best afford it bear most of the cost. The implication is that government should transfer risk away from the financially vulnerable while making others retain the risk. Conceptually, this is how most welfare states operate.

Such an approach may mean giving more support to smaller firms and not-for-profit organisations, which may not have much in the way of financial reserves. Larger companies would receive less aid, as they are expected to have greater reserves. Indeed, the UK government has said it will guarantee 100% of bank loans to eligible smaller business but only 80% of  loans to larger companies.

Productivity

Another consideration is the impact of COVID-19 containment measures on the productive capacity of the economy. Prolonged inactivity means the economy will take much longer to return to its previous growth path. This loss of capacity can take different forms.

  • Physical capital. Capital, from factories to aircraft to coffee machines, can degrade if not used on a regular basis. When the economy is fired up again, some of this capital may have been lost for good or may require significant investment before it can be reused. Even if capital has not degraded, it may devalue due to changes in customer behaviour and demand (e.g. there may be a lasting drop in the property value of restaurant premises or department stores).
  • Human capital. If firms need to lay off employees during the crisis, they lose the experience, skills and relationships that had been contributing to their success. To get back up to capacity, businesses may need to recruit and train new staff at significant cost. Some of what may be lost, including a productive culture, may not be recovered.
  • Financial capital. By taking on debt during the pandemic simply to avoid closing for good, firms will have less capacity for productive investment once the emergency is over. Similarly, if banks are required to extend lending to allow failing businesses to survive, the resulting erosion of their capital base will limit their ability to lend to new businesses to support the return to growth.

The extent to which productive capacity may be reduced, and how quickly it can be reconstituted, will differ by sector. Where barriers to entry are low, growth and capacity can be rebuilt rapidly. Physical capital-intense sectors are unlikely to suffer much of a loss in productive capacity even with a prolonged period of reduced economic activity. Other sectors that rely on specific skills, assets, IP, human capital or complex supplier relationships may be much harder to rebuild. 

Efficiency

Where possible, governments may want to provide incentives for parties to take the right steps to mitigate risks, in order to reduce the overall economic cost. This can be achieved by ensuring that those best placed to alleviate the risks bear at least part of the cost. The inclusion of ‘excess’ payments in insurance contracts is a classic example of this principle.

Accordingly, government support can be targeted at encouraging the right behaviour.  For example, if the aim is to prevent business closure and the resulting loss of capacity the level of aid must be sufficient so that remaining in business (even if dormant) is preferable to closing down.

But support that is too generous may discourage innovation and efficiency.  Economic shocks impose huge costs, but they also stimulate new thinking as firms battle to survive. Witness how some businesses have overhauled their operations to deliver products to customers during the lockdown. The sharing of the economic risk should not deter this type of innovation.

During the phase of maximum restrictions it is inevitable that a lot of government aid will be via simple transfers (i.e. paying people and businesses to do nothing). As the curbs are gradually eased, the government may want to shift the focus of its support to measures that directly stimulate activity.

Therefore, we need to consider two points. First, what is the behaviour we want to encourage during this period and whom do we want to encourage?  Second, how much of the risk do these parties need to bear in order to incentivise the sought-after behaviour? Learning from insurance contracts, the answer may be: only some of the risk.   

Balancing the criteria

The final step is to balance these criteria of fairness, affordability, productivity and efficiency to provide the best outcome possible in the face of the economic risks caused by COVID-19. There is no one-size-fits-all allocation. Only government can judge the trade-off between fairness and efficiency. Recognising the implications of each of these criteria can help steer policymakers. In our next article we’ll take a look at how they may apply in various sectors.

Covid-19

Covid-19

Head over to our hub of insights on the ever-changing situation surrounding the global pandemic.

Discover more