Informal Risk Sharing with Local Information

This paper considers the effect of contracting limitations in risk-sharing networks, arisingfor example from observability, verifiability, complexity or cultural constraints. Wederive necessary and sufficient conditions for Pareto efficiency under these constraints ina general setting, and we provide an explicit characterization of Pareto efficient bilateraltransfer profiles under CARA utility and normally distributed endowments. Our modelpredicts that network centrality is positively correlated with consumption volatility, asmore central agents become quasi-insurance providers to more peripheral agents. The proposedframework has important implications for the empirical specification of risk-sharingtests, allowing for local risk-sharing groups that overlap within the village network