Risk Sorting, Portfolio Choice, and Endogenous Informal Insurance

Xiao Yu Wang

No 20429, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: C78 O1 O17 (search for similar items in EconPapers)
Date: 2014-08
New Economics Papers: this item is included in nep-ent
Note: DEV
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Citations: View citations in EconPapers (1)

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