The Crowding-Out Effect of Formal Insurance on Informal Risk Sharing: An Experimental Study

Abstract

This paper investigates the crowding-out effect of formal insurance on informal risk-sharing arrangements via theory and laboratory experiment. Our model and simulation predict that the crowding out of private transfers is often more than one-for-one and will reduce the total risk coverage. Furthermore, the existence of a moderate degree of altruism exaggerates the crowding-out effect, especially when there is an ex-ante income inequality. These predictions are mostly supported by the laboratory experiment, except that the crowding-out effect is not more than one-for-one, and hence the total risk coverage is not significantly reduced by formal insurance.

Keywords: informal risk sharing, formal insurance, crowding-out effect

JEL Classification: C91, D81, O17