We study how financial conditions shape labor income risk through endogenous firm insurance, job creation, and job destruction. We develop a directed search model with dynamic wage
contracts, two-sided limited commitment, and time-varying risk premia where two forces govern the optimal contract: an insurance motive that smooths wages and a retention motive that deters poaching. When risk premia rise, limited commitment constraints tighten and insurance erodes—especially for low-wage workers near the separation margin—generating state-dependent labor income risk. Using U.S. administrative data, we document consistent evidence: the pass-through of firm productivity shocks to worker earnings rises when risk premia are elevated, concentrated among lower-paid workers and operating through job destruction. The calibrated model matches labor market dynamics, asset prices, and the heterogeneous pass-through of firm shocks. Beyond these targeted moments, it generates realistic variation in non-Gaussian earnings dynamics across workers and over time, sizable welfare losses from idiosyncratic risk, depressed human capital valuations, and large welfare gains from state-contingent policies.
