Incentivizing catastrophe risk sharing

Abstract

Government plays a vital role in improving community resilience against natural disasters. Due to the limited relief capacity of a government, it is desirable to develop a risk-sharing mechanism involving both private sector providers (e.g., insurers, for-profit disaster agencies, and firms that provide resources for risk mitigation and recovery) and the public. In this article, we take catastrophe insurance as an example to examine ways of providing incentives for multilateral risk sharing, especially when it involves socially connected communities. We consider a sequential game with three sets of players, the government, a private insurer, and a community of households. The government determines an optimal subsidy portfolio (including ex ante insurance premium subsidy and ex post relief subsidy) for a community with particular levels of social network influence and risk perception. We characterize the equilibrium purchase rate within the community by positive and negative herding behaviors and identify the government’s optimal subsidy strategy dependent on the available budget and the emphasis on ex post social responsibility. We also extend the game to account for multi-community coverage and multi-year insurance contracts to demonstrate the benefits of spatial and inter-temporal risk pooling.