Pareto-Efficient Risk Sharing in Centralized Insurance Markets with Application to Flood Risk

Abstract

Centralized insurance can be found in both the private and public sectors. This paper provides a micro-economic study of the risk-sharing mechanisms in these markets, where multiple policyholders interact with a centralized monopolistic insurer. With minimal assumptions on the risk preferences of the market participants, we characterize Pareto optimality in terms of the agents' risk positions and their assessment of the likelihoods associated with their loss tail events. We relate Pareto efficiency in this market to a naturally associated cooperative game. Based on our theoretical results, we then consider a model of flood insurance coverage via an illustrative example. The lessons drawn from this example lead to important policy implications for the existing National Flood Insurance Program in the United States.

Keywords: Climate change, flood risk, spatial diversification, risk sharing, Pareto optimality, layer-type indemnities