DP10278 Insurance companies of the poor
We model the emergence of formal insurance institutions as equilibria under limited contract enforceability where groups are required to be coalition-proof but also can use fines for enforcement. The model can generate coexistence of formal and informal groups without requiring heterogeneity in insurance demand, because coalition-proof equilibria can fail to exist. It also predicts where formal insurance is likely to flourish: insurance groups that hold savings become more prevalent the more enforcement power communities have, and the more enforcement power, the better insurance. We use data on Ethiopian funeral insurance groups and their members to motivate and test our model. Those which hold savings and collect regular premia provide better insurance than informal ones, and both sets of groups employ a variety of punishment mechanisms to induce their members to share risk. Despite the observed positive correlation between formality and the quality of insurance, informal and formal groups co-exist. Consistent with predictions generated by the model, we find that standard measures of social cohesion are linked to the use of punishment mechanisms, the quality of insurance and the prevalence of formal insurance institutions.