Risk Sharing

Risk sharing is the distribution of risk among parties, so that the risk is borne by those who are best able to bear it. Risk sharing is a central function of financial markets and of insurance, and it is a key element of the analysis of financial arrangements.

Mechanisms

Risk sharing operates through several mechanisms. Insurance transfers the risk from the insured to the insurer, in exchange for a premium. The insurer can bear the risk more efficiently, since it holds a portfolio of risks that are not perfectly correlated.

Financial markets share risk through the trading of securities. The issuance of shares transfers the risk of the firm's returns to the shareholders, who diversify their holdings. The issuance of debt allocates the risk between the creditors and the shareholders.

Contracts also share risk, through the specification of the payments that are contingent on the outcomes. The design of the contract determines the allocation of the risk between the parties.

Risk Sharing and Growth

Risk sharing is relevant to the analysis of growth, since it affects the willingness of individuals and firms to undertake risky activities. The ability to share risk encourages investment in innovation and in activities with uncertain returns.

The development of financial markets and of insurance contributes to risk sharing, and it is associated with higher rates of growth. The relationship is one of the channels through which financial development affects the economy.

International Risk Sharing

Risk sharing occurs across countries through several channels. The holding of foreign assets allows investors to diversify their portfolios and to share the risk of the domestic economy.

The integration of financial markets increases the scope for international risk sharing, and it can reduce the volatility of consumption relative to income. The evidence suggests that the scope for risk sharing has increased, though it remains limited.

The consumption correlation puzzle refers to the finding that consumption is more correlated across countries than the theory of risk sharing would predict. The puzzle suggests that the barriers to risk sharing are larger than the theory assumes.

Limits

Risk sharing has limits. The problems of asymmetric information, including adverse selection and moral hazard, impede the sharing of risk, since the parties may not be able to observe the relevant characteristics and the actions.

The presence of these problems means that some risks cannot be shared, and that the ones that are shared may be subject to restrictions, including the use of collateral, the imposition of deductibles, and the monitoring of the behaviour of the parties.

The design of the arrangements must address these problems, and it must balance the benefits of risk sharing against the costs of the restrictions that are required.

The Insurance Markets

The insurance markets are the central mechanism for the risk sharing, and they are subject to the problems of the asymmetric information.

The adverse selection arises when the individuals differ in their risk and the insurer cannot observe the risk. The individuals with the higher risk are more likely to buy the insurance, which raises the cost and can lead to the market failure.

The moral hazard arises when the insured can take the actions that affect the risk. The insured with the full coverage has less incentive to avoid the loss, which raises the cost of the insurance.

The design of the insurance contracts addresses these problems through the deductibles, the co-payments, and the other mechanisms. The design must balance the benefit of the risk sharing against the cost of the distortions.

The Financial Intermediation

The financial intermediaries share the risk through the diversification and the pooling. The banks diversify across the borrowers, and the insurers pool the risks of the many policyholders.

The diversification reduces the risk of the individual institution, and the pooling allows the sharing of the risk among the participants. The intermediaries also transform the risk, by holding the illiquid assets and the liquid liabilities.

The risk sharing by the intermediaries can create the systemic risk, since the intermediaries are interconnected and the failure of one can affect the others. The analysis of the risk sharing must consider the systemic dimension.

The International Risk Sharing

The international risk sharing occurs through the holding of the foreign assets and the borrowing across the countries. The integration of the financial markets increases the scope for the risk sharing.

The consumption correlation puzzle refers to the finding that the consumption is more correlated across the countries than the theory of the risk sharing would predict. The puzzle suggests that the barriers to the risk sharing are larger than the theory assumes.

The analysis of the international risk sharing informs the understanding of the effects of the financial integration and of the design of the international financial system.

Summary

Risk sharing is the distribution of the risk among the parties, and it is the central function of the financial markets and of the insurance. The analysis of the mechanisms, of the problems of the asymmetric information, and of the international dimension informs the understanding of the risk sharing.

See also

• Financial Economics
• Behavioural Economics
• Banking