Endogenous Insurance and Informal Relationships

Abstract

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.