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On the Optimal Design of Disaster Insurance in a Federation

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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 invest in infrastructure designed to reduce vulnerability to natural and man-made hazards. We show that when the federal government is committed to full insurance against disasters, regions will have incentives to under-invest in ex-ante 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. For low probability disasters this will result in lower ex-post intergovernmental transfers (and hence less ex-post redistribution) and greater ex-ante investment. However, the second-best transfer scheme suffers from a time-inconsistency problem. Ex-post, the central government will be driven towards full insurance rather than the second-best grants, which results in a type of soft budget constraint problem. Sub-national governments will anticipate this and reduce their investment in protective infrastructure even further. The result is that the central government may be better off suffering the underinvestment that results with first-best transfers because investment is even lower under second-best transfers when the central government is unable to commit.

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  • Timothy J. Goodspeed & Andrew Haughwout, 2011. "On the Optimal Design of Disaster Insurance in a Federation," Economics Working Paper Archive at Hunter College 436, Hunter College Department of Economics.
  • Handle: RePEc:htr:hcecon:436
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    More about this item

    Keywords

    intergovernmental transfers; natural disasters; federalism; risk sharing;
    All these keywords.

    JEL classification:

    • H11 - Public Economics - - Structure and Scope of Government - - - Structure and Scope of Government
    • H12 - Public Economics - - Structure and Scope of Government - - - Crisis Management
    • H7 - Public Economics - - State and Local Government; Intergovernmental Relations
    • R5 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Regional Government Analysis

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