Introduction

This chapter, largely based on Genicot and Ray (2003), discusses group formation in the context of informal insurance arrangements with enforcement constraints.

Risk-Sharing Agreements

Risk is a pervasive fact of life for most people – especially so in developing countries. A high and often extreme dependence on volatile labor markets or agricultural production, widespread poverty, and the lack of access to formal insurance and credit serve to create a particularly acute problem of consumption smoothing. It is not surprising, then, that formal insurance arrangements are supplanted by widespread informal arrangements. Such arrangements are not based on contracts that are upheld by a court of law but on the implicit promise of future benefits from continued participation and its attendant mirror image: the threat of isolation from the community as a whole in the event of noncompliance.

It hardly needs mentioning that there is considerable evidence of mutual insurance in village communities (Morduch 1991; Deaton 1992; Townsend 1994; Udry 1994; Jalan and Ravallion 1999; Ligon, Thomas, and Worrall 2002; Grimard 1997; Gertler and Gruber 2002; Foster and Rosenzweig 2001). What is more interesting is that the same studies reveal a large departure from the ideal of perfect insurance. It is only natural to invoke various incentive constraints to explain the shortfall. Asymmetry of information, moral hazard, and the lack of enforceability are all potential impediments to widespread risk sharing.

Of these three factors, it appears that the most important constraint arises from the inability to enforce risk-sharing agreements.