Protecting the Vulnerable: the Tradeoff between Risk Reduction and Public Insurance

In a risky world should governments provide public goods that reduce risk or compensate the victims of bad outcomes through social insurance? This article examines a basic question in designing social protection policies: how should a government allocate a fixed budget between these two activities? In the presence of income and risk heterogeneities a simple public insurance scheme that pays a fixed benefit to all households that suffer a negative shock is an effective redistributional instrument of public policy. This is true even when a well functioning private insurance market exists, and so the role of public insurance is not to correct a market failure. In fact, the existence of a private insurance market means that the public system has desirable targeting properties--all but the poor and high-risk take up private insurance. The provision of public goods that reduce risk for all should therefore be complemented with public insurance that (automatically) benefits those who are especially vulnerable. Copyright 2007, Oxford University Press.