Catastrophe risk sharing among individuals, private insurance, and government

Abstract Limited research has been conducted on the optimal public–private risk‐sharing for catastrophe risks. This paper develops a theoretical framework to study the risk‐sharing decisions and interactions of three types of catastrophe‐market participants: a large number of individuals, a large number of private insurers in a competitive market, and a government that can choose between alternatives of re/insurance or ex post relief. Our analysis shows that the optimal government intervention varies depending on the correlation levels among individual losses. For moderately positive levels of loss correlation, it is optimal for the government to offer an ex post relief program to supplement private insurance. However, for higher levels of loss correlation, government reinsurance becomes optimal, although not to the extent of replacing private insurance if the government is less efficient than private firms. In sum, as catastrophe‐loss correlations increase, that is, as the risk becomes more catastrophic, more risk‐sharing tools and funding are needed to maximize social welfare.