Endogenous Insurance and Informal Relationships
63 Pages Posted: 19 Jul 2013 Last revised: 27 Feb 2015
Date Written: February 23, 2015
Heterogeneously risk-averse individuals who lack access to formal insurance build and use relationships with each other to manage risk. I show that the composition of equilibrium relationships under pairwise matching and when group size is endogenous is determined by a mean-variance trade-off across differentially risky productive opportunities, though output distributions may have infinitely-many nonzero cumulants. This has important policy implications. For example, a policy which ignores the equilibrium response of informal institutions may exacerbate inequality and hurt most those it intended to help: a reduction in aggregate risk may lead to an increase in risk borne by the most risk-averse individuals, as the least risk-averse abandon their roles as informal insurers. The theory also sheds light on the channels through which endogenous insurance relationships influence informal firm structure and entrepreneurship.
Keywords: assortative matching, risk sharing, informal insurance, formal insurance, group formation
JEL Classification: O1, O13, O16, O17, C78
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