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. We explore the optimal insurance scheme in a federal system, building on the model of Persson and Tabellini (1996). We begin with a simple set-up with 2 regional governments and a central government. Income contains both certain and uncertain components, with the latter subject to an i.i.d. shock (the disaster or terrorist attack). States can use certain income to invest in protective infrastructure (such as levies or police). By doing this, states will affect the probability that they end up in the high or low income state. We explore two distinct reasons why states might under-invest in infrastructure, and the optimal federal insurance policy in each case. First, to the extent that states can alter the probability of ending up in a low/high income state, there will be a moral hazard problem. While the central government will be unable to achieve a first-best (with no uncertainty) outcome, we explore the optimal contract that will get the state to invest the most under the constraints. Second, if the regional government is viewed as investing first in the expectation that the central government will compensate for losses incurred, a soft-budget constraint problem will arise. We discuss these results in light of disaster policy in the US. I