Household Use of Open‐End Credit to Finance Risk

Consumers face many risks which can neither be avoided nor completely controlled. Personal property, for example, is exposed to such risks as fire, theft, vandalism, and product defects. After taking precautions to minimize the frequency and severity of potential losses, the household must decide what proportion of the residual risk to retain and what proportion to transfer to outside agents through contingent claims contracts. A related question, and one which has been less extensively studied, is the degree to which retained risk should be financed on a preloss or postloss basis; that is, with cash or credit. This paper addresses both issues by examining the use of open-end consumer credit as a means of financing household risk. The two dimensions of the risk financing problem create four options, as shown in Table 1. As the table suggests, postloss transfers in the form of retroactive insurance--that is, policies providing back-dated coverage--do exist (Smith and Witt 1985), but the vast majority of transfers involve preloss financing, in which a surety contract is purchased prior to a loss. Thus, the risk of accidental property loss is often transferred to an insurance company, while the risk of product failure may be transferred by purchasing an extended warranty from the manufacturer or a service contract from a third party. Retained risk, on the other hand, has traditionally been financed through self-insurance, in which the consumer sets aside a pool of emergency funds for possible future use in the event of a loss. Although preloss transfers and self-insurance are perhaps the most common methods of financing risk, they may not always be the most economical. The alternative is to establish open-end credit so that funds are available for contingencies, but no expense is incurred unless and until a loss actually occurs. Using credit guarantees to finance risk is a familiar technique in corporate risk management (e.g., Doherty 1985), and during the last two decades, the issuance of standby letters of credit by commercial banks has proceeded at a rapid pace (Goldberg and Lloyd-Davies 1985; Koppenhaver and Stover 1991). Similarly, the use of credit to finance risk is becoming increasingly popular among consumers. As Hayes recently observed, "Many consumers now seem to use credit to smooth out the effects of temporary economic fluctuations and to maintain living standards" (1989, 19). But an analysis of this option has been neglected in most of the literature on household risk management. Even leading textbook authors, such as Williams and Heins (1989), are silent on this issue. This paper attempts to fill the void by including consumer credit in a model of risk financing. Under certain conditions derived below, using credit can be a more affordable and more flexible method of financing small household risks, particularly risks to personal property. The paper is organized as follows. First, consumer credit is compared with preloss insurance coverage as a means of financing risk. (Because it is virtually unavailable to consumers, retroactive insurance is not considered.) A two-period utility maximization model is used to define the conditions under which postloss credit financing is preferred to insurance. The model is then reinterpreted in order to compare consumer credit with product service plans. Next, credit is compared with the traditional self-insurance method of retention. A brief discussion section concludes the paper. TABLE 1 Risk Financing Methods TRANSFER RETENTION PRELOSS insurance self-insurance service contracts warranties POSTLOSS retroactive insurance credit INSURANCE VERSUS CREDIT Insurance policies covering personal property such as automobiles require the payment of premiums in advance of coverage and on a continuing basis, in return for contingent claims in the event of a loss. …