Formal Insurance and Informal Risk Sharing Dynamics

Abstract

This paper investigates whether and how the crowding-out effect of formal insurance on informal risk sharing is mitigated by social preference change. We design a lab experiment in which formal insurance is introduced and removed unexpectedly in a repeated risk-sharing game. We find evidence of social preference change by showing that informal risk sharing is significantly improved after the removal of formal insurance, and the pattern mainly occurs when one subject obtains insurance but the other does not. Findings suggest that it is the insurance purchasers who take the initiative to share more risk for their partners. However, there is no significant improvement in informal risk sharing when insurance purchasing decisions are randomly computer generated. We propose a model based on guilt aversion to explain our findings.