Natural Catastrophe Insurance: When Should the Government Intervene?

Abstract

The present research relaxes three of the usual assumptions made in the insurance literature. It is assumed that (1) there is a finite number of risks, (2) the risks are not statistically independent and (3) the structure of the market is monopolistic. In this context, the article analyses two models of natural catastrophe insurance: a model of insurance with limited liability and a model with unlimited guarantee. Among others, the results confirm the idea that the natural catastrophe insurance industry is characterized by economies of scale. The government should consequently encourage the emergence of a monopoly and discipline the industry through regulated premiums. It is also shown that government intervention of last resort is not needed when the risks are highly correlated. Lastly, the results point out that when the risks between two regions are not sufficiently independent, the pooling of the risks can lead to a Pareto improvement only if the regions face similar magnitude of damage. If not, then the region with low-damage events needs the premium to decrease to accept the pooling of the risks.

Keywords: Insurance, Ruin, Natural Catastrophe, Market Failure, Government Intervention

JEL Classification: G22, G28