The Welfare Economics of Catastrophe Losses and Insurance

This paper uses the tools of welfare economics to analyse the appropriate mix of private sector and government responses to catastrophic events. In particular, we examine the appropriate roles of post-disaster government aid, private insurance and mitigation activities. The analysis focuses on the distinction between the ex ante and ex post welfare criteria, as well as incentive issues such as may arise from the Samaritan's dilemma. A key factor is that individuals maintain differing subjective beliefs concerning the probability or magnitude of the catastrophic event. The analysis applies to insurance markets certain concepts that are now also being developed in the finance literature to examine the efficiency of naked credit default swaps and other instruments that are in essence side bets among agents with heterogeneous beliefs. We conclude that ex post welfare economics provides fundamental insights that have not been previously integrated into the discussions concerning the losses created by catastrophic events, including a potential role for mandatory insurance.