Promoting Efficient Institutions and Providing Insurance Services: A Dual Role for Multilateral Agencies

Abstract

This paper uses a Costly State Verification model to analyze risk-sharing arrangements between a coalition of countries when there is uncertainty about the realization of a key performance variable. The realization of the performance variable is a country's private information, and the cost of verifying performance differs across countries. The cost of verification reflects the "transparency" of a country's institution. We characterize the constrained optimal multilateral insurance contract and show that forming a coalition provides complete risk sharing across countries and across states - the total cost of verification of the coalition is shared equally by all countries. This cost sharing feature of the contract generates a negative externality and results in moral hazard. We also show that high verification costs limits the number of countries that can participate in risk sharing and may result in "insurance rationing" - some countries are excluded from the coalition although they prefer to join. This provides a rationale for the coalition to implement policies that will promote transparency and accountability in member countries. We then analyze a policy that a multilateral agency with limited enforcement powers may use to ameliorate these problems.

Keywords: Contracts, Costly State Verification, Insurance, International Risk Sharing, Multilateral Organizations

JEL Classification: D8, F33