The insurance premium in the interest rates of interlinked loans in a small-scale fishery

Abstract

Interest payments based on income flows are a common feature of informal loans. Such so-called ’interlinked loans’ can be seen as insurance against very low disposable incomes, as interest payments are lowest when income turns out to be low. This paper examines whether interlinked loans indeed contain an insurance premium and how those premia are determined. A simple theoretical model predicts that interest rates of interlinked loans increase with income volatility when insurance premia exist. Based on data from a small-scale fishery in India, calculations show that, on average, lenders receive 25 per cent of the income, which corresponds to an average interest rate of 49 per cent p.a. A panel data analysis confirms theoretical predictions that interlinked loans contain an insurance component paid by the borrowers.