Risk Sorting, Portfolio Choice, and Endogenous Informal Insurance

68 Pages Posted: 3 Sep 2014 Last revised: 28 Apr 2021

Multiple version iconThere are 2 versions of this paper

Date Written: August 2014

Abstract

Heterogeneously risk-averse individuals who lack access to formal insurance build and use relationships with each other to manage risk. I study the formation of these relationships. I show that the composition of equilibrium groups under pairwise matching and when group size is endogenous is determined by a trade-off in expected return and variance of return (captured by the coefficient of variation) across differentially risky productive opportunities, even when output distributions are skewed and 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. Understanding informal occupations as equilibrium choices as opposed to exogenous assignments generates insights into the role played by endogenous insurance relationships in shaping informal firm structure and the development of entrepreneurship.

Suggested Citation

Wang, Xiao Yu, Risk Sorting, Portfolio Choice, and Endogenous Informal Insurance (August 2014). NBER Working Paper No. w20429, Available at SSRN: https://ssrn.com/abstract=2490839

Xiao Yu Wang (Contact Author)

Duke University ( email )

100 Fuqua Drive
Durham, NC 27708-0204
United States

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