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Risk Sorting, Portfolio Choice, and Endogenous Informal Insurance

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  • 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.

Suggested Citation

  • Xiao Yu Wang, 2014. "Risk Sorting, Portfolio Choice, and Endogenous Informal Insurance," NBER Working Papers 20429, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:20429
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    JEL classification:

    • C78 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Bargaining Theory; Matching Theory
    • O1 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development
    • O17 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Formal and Informal Sectors; Shadow Economy; Institutional Arrangements

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