On the efficiency of insurance institutions under interdependent risks

Abstract

We theoretically investigate the equilibria and efficiencies of public and market insurance institutions within a framework where loss probabilities are interdependently influenced by the efforts of individuals and institutions (firms). We highlight the multilateral nature of interdependency, which exists within individuals, within firms, and between them. Our analysis reveals that both public and market institutions fall short of achieving first‐best efficiency, and that the relative efficiencies between the two are indeterminate, due to the externalities. Regarding effort levels, we find that under the public institution, individual efforts are lower while institutional efforts are higher compared with the social optimum and the market institution. We also find that individual and/or institutional efforts are lower under the market institution than the social optimum, with both efforts lower under severe externalities.