Mutual insurance and limited commitment: Theory and evidence from village economies

We study efficient insurance arrangements when there is complete information but limited commitment because only limited penalties can be imposed if households renege on their promises. Insurance arrangements must therefore take into account the fact that households will renege if benefits from doing so outweigh costs. Using a general dynamic model with Markovian aggregate and idiosyncratic uncertainty, we show that efficient arrangements are characterised by a simple updating rule, similar to a simple debt contract with occasional forgiveness. We use Indian village data to test the theory against three alternatives: autarky, full insurance, and a static model of limited commitment