Livestock Disease Indemnity Design When Moral Hazard is Followed by Adverse Selection

Averting or limiting the outbreak of infectious disease in domestic livestock herds is an economic and potential human health issue that involves both the government and individual livestock producers. Producers have private information about preventive biosecurity measures they adopt on their farms prior to outbreak (ex ante moral hazard), and following outbreak they possess private information about whether or not their herd is infected (ex post adverse selection). We investigate how indemnity payments can be designed to provide incentives to producers to invest in biosecurity and report infection to the government, while simultaneously addressing the information asymmetry between producers and the government. We show how addressing the adverse selection problem leads to a risk-sharing tradeoff in the moral hazard problem. We compare the relative magnitude of the first- and second-best levels of biosecurity investment and indemnity payments to further demonstrate the tradeoff between risk-sharing and efficiency, and we discuss the implications for status quo U.S. policy.