Risk-Based Pricing and Risk-Reducing Effort: Does the Private Insurance Market Reduce Environmental Accidents?

Abstract

This paper examines whether risk-based pricing promotes risk-reducing effort. Such mechanisms are common in private insurance markets, but are rarely incorporated in government assurance programs. We analyze accidental underground fuel tank leaks - a source of environmental damage to water supplies - over a fourteen-year period, using disaggregate (facility-level) data and policy variation in financing the cleanup of leaking tanks over time. The data suggest that eliminating a state-level government assurance program and switching to private insurance markets to finance cleanups reduced the frequency of costly underground fuel storage tanks leaks by more than 20 percent. This corresponds to more than 3,000 avoided fuel-tank release accidents over eight years in one state alone, a benefit in avoided cleanup costs and environmental harm exceeding $400 million. These benefits arise because private insurers mitigate moral hazard by providing financial incentives for tank owners to close, replace or upgrade leak-prone tanks prior to accidents that require costly cleanup.

Keywords: Environmental Regulation, Risk-based Pricing, Insurance, Public Fund, Underground Storage Tank

JEL Classification: K32, L51, M21, G22