Friday, March 28, 2008

Optimal Disaster Insurance

On the Optimal Design of Disaster Insurance in a Federation
by Timothy J. Goodspeed and Andrew F. Haughwout

Abstract: Recent experience with disasters and terrorist attacks in the US indicates that state and local governments rely on the federal sector for support after disasters occur. But these same governments are responsible for investing in infrastructure designed to reduce vulnerability to natural and man-made hazards. This division of responsibilities – regional governments providing protection from disasters and federal government providing insurance against their occurrence – leads to the tension that is at the heart of our analysis. We explore these tensions building on the model of Persson and Tabellini (1996). We show that when the federal government is committed to full insurance against disasters, regions will have incentives to underinvest in costly protective measures. We derive the structure of the optimal second-best insurance system when regional governments choose investment levels non-cooperatively and the central government cannot verify regional investment choices. Surprisingly, second-best transfer levels (and the corresponding regional investment levels) can be greater or less than their first-best counterparts, depending on the relative probability of a disaster. If the probability of a disaster is low, secondbest transfers will be designed to reward regions that succeed in avoiding disasters and punish those that do not, thereby giving regions an incentive to increase investment in protective infrastructure. However, this raises the further question of whether the central government can credibly commit to such a scheme, and we find that ex-post an optimizing central government will decrease transfers if a region provides protective infrastructure that increases its expected future income, generating a soft-budget constraint for regions. This provides an additional incentive for regions to underinvest in protective infrastructure. We discuss these results in light of recent disaster policy outcomes in the US.

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