Absorbing shocks by accumulating risk: Do financially stressed households take on underinsurance risk to manage liquidity constraint?
Melbourne Institute Working Paper No. 16/23
Date: November 2023
Author(s):
Abstract
This paper considers an important facet of emerging household risk. Using Australian panel data, the analysis focuses on liquidity-constrained households and the potential for households to reduce insurance coverage as a way to correct their balance sheets after a shock. The results show not only that underinsurance occurs across the income distribution but also that the greatest reductions occur amongst the most liquidity-constrained households. Moreover, the results suggest a substitution effect by which stressed households reduce coverage in order to maintain spending on the contractual commitments that characterise the large and illiquid balance sheets of liquidity-constrained households. As well as demonstrating an important dynamic of risk accumulation arising from financial stress, the results make a key contribution to the insurance literature in revealing a significant new driver of underinsurance. More broadly, by presenting a vivid dynamic of household shock absorption through the accumulation of new risk, the analysis contributes to debates about how risks are shared between households and markets as household balance sheets expand.