<mark>In another landmark paper Townsend (1984) discusses the literature on Arrow –Debreu complete risk markets and tests the hypothesis using data from a sample of poor South India villages.</mark><sup>5</sup> <mark>The key risk allocation methodologies described are 1) diversification of land holdings by space and crop; 2 ) inter-temporal grain storage; 3) purchases and sales of assets; 4) borrowing; and 5) informal insurance mechanisms involving gifts and transfers within family networks. The advantage of the general equilibrium approach is that it overcomes the need to look at each risk sharing mechanism separately. As with similar studies on the US population the hypothesis of complete risk markets is rejected. However in the case of the South India it was noted that, while household income mattered statistically, consumption varied considerably less than income. From a formal insurance perspective this surfaces the need for very specific understanding of where and how formal risk transfer fits into the overall consumption portfolio of an entity (sovereign, enterprise or household), operating in otherwise incomplete markets.</mark> In a seminal paper Arrow (1965, republished in 1971 and 1992) states that insurance ‘is of considerable importance in the economies of advanced nations’, but that ‘economic theorists have had little to say about it’.<sup>6</sup> On the other hand, ‘insurance theory has developed with virtually no reference to basic economic concepts of utility and productivity’. In this paper he uses the term ‘insurance’ in its most generic sense, and identifies the main institutions for the transfer of risk as the insurance industry and the capital markets. Key insights include the fact that risks should ideally be ‘shifted’ to the agency best able to bear them (including government) and that the main constraining factor in the development of risk transfer markets is moral hazard but that techniques could be developed to address such constraints.

<mark>Autor (2010) similarly asserts that ‘There is an exceedingly strong economic case for many types of insurance. Efficient insurance markets can unequivocally improve social welfare’, and explores why incomplete insurance markets exist. Broad reasons given are:</mark>

1. Credit constraints - people cannot afford insurance and hence must bear risk.

3. Adverse selection—individuals’ private information about their own ‘riskiness’ causes insurers not to want to sell policies to people who want to buy them.

4. Moral hazard (‘hidden action’)—once insured, people take risky/costly actions that they otherwise would not.

Merton and Bodie (2005) posit that the core financial sector functions (information flows, capital intermediation, liquidity support and risk transfer) are exogenous but that the institutions and markets that facilitate these functions are endogenous, being the outworkings of economic development and other country specific factors. They argue that neoclassical economics defines the equilibria to which financial markets trend as they overcome various frictions and behavioral distortions (assuming a well-run economy). Examples provided include the unbundling of life insurance products as more efficient investment intermediaries such as mutual funds emerged in North America. In similar vein Mey (2007) has described the disintermediation of natural catastrophe risk to capital markets. The authors assume a Solow model of economic growth, which emphasizes the central role of technological advancement, and propose a link to contemporary studies showing that ‘well-functioning financial institutions promote economic growth’. Finally they warn that the stifling of financial innovation ‘for fear of reducing the effectiveness of short run monetary and fiscal policy’ can lead to a much slower pace of technological progress.

> 5 <mark>The methodology could conceptually have been applied to other populations where cooperative action could potentially lead to Pareto optimality.</mark>

> 6 Demirguc-Kunt and Levine (2008) highlight the non appearance of the financial sector as a whole in much of the development literature.

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