Optimal Risk Allocation in the Provision of Local Public Services: Can a Private Insurer be Better Than a Federal Relief Fund?

We study the institutional solutions needed in a decentralized framework to cope with the potential adverse welfare effects caused by localized negative shocks, that impact on the provision of public services and that can be limited by precautionary investments. We consider first a public relief fund to cover these ‘collective risks’. We analyse the underinvestment problem stemming from the moral hazard of Local administrations, when investments are defined at the local level and are not observable by the Central government that manages the relief fund. We then examine the potential role of private insurers in solving the underinvestment problem. Our analysis shows that the public fund is almost always a better institutional arrangement with respect to the private insurance solution, but competitive private insurers can improve social welfare in the presence of Central government’s soft budget constraints problems, especially when the number of Local administrations is large. (JEL codes: H23, H77, G22).