We study how aggregate financial conditions shape the extent of firm insurance and, through it, labor income risk. In a directed search model with dynamic wage contracts and two-sided limited commitment, firms partially insure workers against idiosyncratic shocks, but that insurance erodes when risk premia rise, employment relationships lose value, and labor markets become slack. The key implication is that the pass-through of firm shocks to worker earnings rises in bad times, especially for lower-paid workers near the separation margin. Using U.S. administrative data, we document new evidence consistent with this prediction and use our estimates to quantitatively discipline the model. The model implies large welfare costs of residual labor income risk, high risk premia for human capital, and that recession-contingent labor market transfers improve welfare.
