Collective Risks in Local Administrations: Can a Private Insurer Be Better than a Public Mutual Fund?

In this paper we consider the institutional arrangements needed in a decentralised framework to cope with the potential adverse welfare effects caused by localized negative shocks (e.g., natural disasters, terrorist attacks, or even clinical errors) that can be limited by precautionary investments. We model the role of a public mutual fund to cover these “collective risks”. We start from the under-investment problem stemming from the moral hazard of Local administrations when the fund is managed by the Central government, which also takes into account the equalisation of resources across administrations. We then study the potential role of private insurers in solving the under-investment problem. Our analysis shows that the public fund is always superior to the private insurance solution in the presence of hard budget constraints. However, when the Central government cannot credibly commit to an optimal transfer rule, private insurers are sometimes able to improve on the public mutual fund solution by inducing a higher level of investments.