Do the Poor Benefit Less from Informal Risk-Sharing? Risk Externalities and Moral Hazard in Decentralized Insurance Arrangements

Abstract

Empirical evidence on developing countries highlights that poor farm-households are less keen to adopt high risk/high return technologies than rich households. Yet, they tend to be more vulnerable to income shocks than the rich. This paper develops a model of informal risk-sharing with endogenous risk-taking which provides a rationale for these observations. In our framework, informal risk-sharing is incomplete due to risk externalities, which leads to moral hazard. We compare the first best and second best to a decentralized bargaining process, where the lack of coordination amplifies moral hazard. The analysis of group composition yields counterintuitive results. First, if groups are homogeneous, poor groups share less risks than rich groups even though the rich take more risks. Second, the insurance level of rich households decreases in the presence of poor households, potentially making them reluctant to share risk with poorer households.