Natural Disaster Risk Bearing Ability of Governments: Consequences of kinked utility

Abstract

In this paper the risk neutrality paradigm for government stocks and investments is challenged within the context of catastrophe risk. We focus on government’s ability to spread its natural disaster risk. Based on the classical approach of Arrow and Lind, the paper shows the weaknesses of and reformulates the risk neutral assumption for government decisions under uncertainty. The rationale that governments have kinked utility functions, which can arise from natural disaster events, is given through a network example and its implications explained considering also risk aversion and the benefits of different types of risk management strategies.