Working Paper: NBER ID: w20429
Authors: Xiao Yu Wang
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.
Keywords: risk management; informal insurance; portfolio choice; endogenous relationships; entrepreneurship
JEL Codes: C78; O10; O17
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| risk management strategies (H12) | composition of equilibrium groups (D50) |
| risk management strategies (H12) | informal insurance relationships (G52) |
| reduction in aggregate risk (D81) | loss of informal insurance for risk-averse individuals (G52) |
| loss of informal insurance for risk-averse individuals (G52) | increased vulnerability for risk-averse agents (D81) |
| higher expected returns (G12) | higher variance of returns (G17) |
| higher variance of returns (G17) | structure of informal insurance (G52) |