Poverty Traps and Disaster Insurance in a Bi-Level Decision Framework

29 Pages Posted: 31 Jan 2020

See all articles by Raimund M. Kovacevic

Raimund M. Kovacevic

University of Vienna

Willi Semmler

The New School - Department of Economics; Universitaet Bielefeld; IIASA

Date Written: November 4, 2019

Abstract

In this paper, we study mechanisms of poverty traps that can occur after large disaster shocks. Our starting point is a stylized deterministic dynamic model with locally increasing returns to scale possibly generating multiple equilibria paths with finite upper equilibrium. The deterministic dynamics is then overlayed by random dynamics where catastrophic events happen at random points of time. The number of events follows a Poisson process, whereas the proportional capital losses (given a catastrophic event) are beta distributed. In a setup with fixed insurance premium per unit of insured capital, a fraction of the capital might be insured, and this fraction may change after each event. We seek an optimal strategy with respect to the insured fraction. Falling below the unstable equilibrium of the deterministic dynamics introduces the possibility of ending up in a poverty trap after the disaster shocks. We show that the trapping probability is equal to one, even when the stable upper equilibrium of the deterministic dynamics exists. This is true regardless of the chosen amount of insured capital. Optimization then is done with the expected discounted capital after the next catastrophic event as the objective. Our model may also be useful to assess risk premia and creditworthiness of borrowers when a sequence of shocks at uncertain times and of uncertain size occurs.

Keywords: disaster insurance, trapping probability, and poverty traps

JEL Classification: C 61, C 63, L 10, L 11 and L 13

Suggested Citation

Kovacevic, Raimund M. and Semmler, Willi, Poverty Traps and Disaster Insurance in a Bi-Level Decision Framework (November 4, 2019). Available at SSRN: https://ssrn.com/abstract=3515648 or http://dx.doi.org/10.2139/ssrn.3515648

Raimund M. Kovacevic

University of Vienna

Bruenner Strasse 72
Vienna, Vienna 1090
Austria

Willi Semmler (Contact Author)

The New School - Department of Economics ( email )

65 Fifth Avenue
New York, NY 10003
United States

HOME PAGE: http://www.newschool.edu/nssr/faculty/?id=4e54-6b79-4e41-3d3d

Universitaet Bielefeld ( email )

Universit├Ątsstra├če 25
Bielefeld, NRW
Germany

IIASA ( email )

Schlossplatz 1
Laxenburg/Austria, A-2361
Austria

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