Working Paper: CEPR ID: DP10278
Authors: Tessa Bold; Stefan Dercon
Abstract: We model the emergence of formal insurance institutions as equilibria under limited contract enforceability where groups are required to be coalition-proof but also can use fines for enforcement. The model can generate coexistence of formal and informal groups without requiring heterogeneity in insurance demand, because coalition-proof equilibria can fail to exist. It also predicts where formal insurance is likely to flourish: insurance groups that hold savings become more prevalent the more enforcement power communities have, and the more enforcement power, the better insurance. We use data on Ethiopian funeral insurance groups and their members to motivate and test our model. Those which hold savings and collect regular premia provide better insurance than informal ones, and both sets of groups employ a variety of punishment mechanisms to induce their members to share risk. Despite the observed positive correlation between formality and the quality of insurance, informal and formal groups co-exist. Consistent with predictions generated by the model, we find that standard measures of social cohesion are linked to the use of punishment mechanisms, the quality of insurance and the prevalence of formal insurance institutions.
Keywords: institutions; insurance; limited commitment; savings; social capital
JEL Codes: C73; D02; E21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| enforcement ability of communities (P14) | prevalence of formal insurance groups (G52) |
| stronger enforcement (P14) | better insurance outcomes (G52) |
| higher enforcement capabilities (K40) | sustain contracts with savings (D86) |
| sustain contracts with savings (D86) | better risk-sharing and welfare outcomes (D69) |
| formal insurance groups with savings (G22) | better insurance than informal ones (G52) |
| financial penalties for noncompliance (G38) | enhanced degree of insurance (G52) |
| social cohesion (Z13) | use of punishment mechanisms (K42) |
| groups that save (D14) | less consumption drop after death shocks (D15) |