On the optimal design of disaster insurance in a federation

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 tensions that are at the heart of our analysis. We show that when the federal government is committed to full insurance against disasters, regions will have incentives to under-invest 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. Normally (though not always) this will result in lower intergovernmental transfers and greater investment. However, the second-best transfer scheme suffers from a time-inconsistency problem. Ex-post, the central government will be driven towards equalizing 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. We discuss these results in light of recent disaster policy outcomes in the US.