Risk insurance in a transition economy

The hypothesis of Pareto‐optimal risk‐sharing is tested in a transition economy using a new dataset of a representative sample of 364 rural households from Romania. Income shocks are identified as instances of adverse weather, crop failure, animal diseases, illness, and unemployment spells. Despite limited participation of Romanian rural households in formal insurance and credit markets, we fail to reject the hypothesis of full insurance of total non‐durable consumption and its components. Survey responses indicate that the main channels of consumption smoothing are self‐insurance (for adverse weather, crop failure and animal diseases), public transfers (for unemployment spells, maternity and childcare), and to a lesser extent, family ties. We find that adverse weather is associated with higher growth rates of non‐food expenditures. Furthermore, richer households are better able to cope with crop failure than poorer households. An alternative explanation to our not rejecting the hypothesis of full insurance is that some shocks to consumption (such as illness) play the role of preference shifters of the utility function.