Human Capital Risk, Contract Enforcement, and the Macroeconomy

By Tom Krebs, Moritz Kuhn and Mark Wright

http://d.repec.org/n?u=RePEc:iza:izadps:dp9228&r=dge

We use data from the Survey of Consumer Finance and Survey of Income Program Participation to show that young households with children are under-insured against the risk that an adult member of the household dies. We develop a tractable macroeconomic model with human capital risk, age-dependent returns to human capital investment, and endogenous borrowing constraints due to the limited pledgeability of human capital. We show analytically that, consistent with the life insurance data, in equilibrium young households are borrowing constrained and under-insured. A calibrated version of the model can quantitatively account for the life-cycle variation of life-insurance holdings, financial wealth, earnings, and consumption inequality observed in the US data. Our analysis implies that a reform that makes consumer bankruptcy more costly, like the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, leads to a substantial increase in the volume of both credit and insurance.

Young adults are under-insured because they are optimistic about the risks they face. This paper shows that their in an important other reason: they face a large future income risk they cannot insure because they are borrowing constraint. As they have current low income, but much better prospects if they build human capital, they want to borrow and spend on consumption, human capital accumulation, and insurance. As they cannot borrow enough, insurance is the principal loser. This could be alleviated by changing legislation by making bankruptcy more costly and thus making credit more enforceable.

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