Formal insurance, risk sharing, and the dynamics of other-regarding preferences

 Hanna Freudenreich, Marcela Ibanez, Stephan Dietrich, Oliver Musshoff

In the absence of formal financial markets, many poor households rely on the mutual exchange of transfers within informal risk-sharing networks to protect themselves against adverse events. In this paper, we present a model that explains the impact of formal insurance on the dynamics of other-regarding preferences. We test the model's predictions using a solidarity game with rural households in Mexico. Consistent with the model predictions, we find that when shocks are collective, there is a crowding-out effect on transfers and a decrease in trust on insured participants. However, when shocks are idiosyncratic, we fail to confirm the predictions of the model. Transfers to non-insured members are significantly higher when insurance is available to some network members than in a control treatment when insurance is not available. This unexpected crowding-in effect on transfers leads to an increase In trust among non-insured participants. These findings suggest a need to find optimal insurance designs that minimize the crowding-out effect of formal insurance on informal risk-sharing and other-regarding preferences.