Sharing Risk under Heterogeneity: Participation in Settings of Incomplete Information

Abstract

Motivated by the emergence of new Peer-to-Peer insurance organizations that rethink how insurance is organized, we have proposed a theoretical model of decision-making in risk-sharing arrangements with risk heterogeneity and incomplete information about the risk distribution as core features. For these new, informal organizations, the available institutional solutions to heterogeneity (e.g., mandatory participation or price differentiation) are either impossible or undesirable. Hence, we need to understand the scope conditions under which individuals are motivated to participate in a bottom-up risk-sharing setting. The model considers participation as a utility-maximizing alternative for agents with higher risk levels, agents who are more risk averse, are driven more by solidarity motives, and less susceptible to cost fluctuations. This basic micro-level model is used to simulate decision-making for agent populations in a dynamic, interdependent setting. Simulation results show that successful risk-sharing arrangements may work if participants are driven by motivations of solidarity or risk aversion, but this is less likely in populations more heterogeneous in risk, as individual motivations can less frequently make up for larger cost deficiencies. At the same time, more heterogeneous groups deal better with uncertainty and temporary cost fluctuations than more homogeneous populations do. In the latter, cascades following temporary peaks in support requests more often result in complete failure, while under full information about the risk distribution this would not have happened.