Risk Sharing in Highly Incomplete Markets: The Role of Insurance Companies

Abstract

This paper analyzes how insurance companies allow the issue of market incompleteness to be overcome. A general equilibrium economy is considered in which heterogeneous agents face endowment risks. Markets are incomplete: there are only markets for trading commodities ex-post and hedging price risks ex-ante. I introduce insurance companies supplying individual insurance contracts against endowment risks and sharing their uncertain profit through stock markets. I show that this restores Pareto optimality and generates the allocation obtained in the complete Arrow-Debreu setting despite drastically fewer markets. Substituting a tremendous amount of illiquid financial markets by insurance companies seems to be an effective way to implement risk management in the real world.