Mutual Savings and Ex-Ante Payments: Group Formation in Informal Insurance Arrangements

This paper explores whether an informal insurance arrangement can be structured in a manner that relaxes the limited commitment constraints, and thus, increases the benefits from risk sharing by enlarging the contract space to include mutual savings and ex-ante transfers.

The paper argues that:

• Introducing mutual savings and ex-ante transfers can significantly increase the maximum stable group size in a community and the benefits from insurance;
• Without savings, ex-ante transfers can only play a limited role in alleviating limited commitment constraints.

The paper:

• Sets up a model of group formation in informal insurance arrangements with mutual savings and stationery ex-ante and ex-post transfers in a dynamic programming framework;
• Presents a variety of computed examples that study the interplay of mutual savings and ex-ante transfers;
• Imposes an upper bound on capital that can be held in the communal savings fund and explores the implications of such a bound;
• Presents a data set on funeral insurance in rural Ethiopia to examine whether its premise is borne out in practice.

The paper concludes that:

• In the presence of limited commitment, the combination of mutual savings and ex-ante transfers allows higher quality of coverage and increases the maximum stable size of an insurance arrangement;
• Savings and insurance can be structured to complement each other in order to increase the benefits from informal insurance.