Government relief is offered for a wide range of risks--natural disaster, economic dislocation, sickness, and injury. This article explores the effect of such relief on incentives and the allocation of risk in a model with private insurance. It is shown that government relief is inefficient, even when its level is less than the private insurance coverage that individuals would otherwise have purchased and even when private insurance coverage is incomplete due to problems of moral hazard.
A number of important risks--natural disaster, economic dislocation, sickness, and injury--sometimes give rise to government relief. 1 This article examines the effect of such relief on incentives and the allocation of risk in a model with private insurance. The primary conclusion is that govemment relief distorts individuals' incentives: individuals' decisions take into account only their own exposure to loss--the portion of loss uncompensated by government relief--rather than the total loss. Moreover, given the availability of private insurance, the resulting loss from distorted incentives exceeds any benefit from relief in allocating risk.
This article begins with the straightforward situation in which insurance companies can observe individuals' risk-reducing behavior. In this case, as is well recognized, insurance policies in which premiums are based on behavior allow individuals to achieve a first-best outcome (in which insurance against loss is complete and incentives are not distorted) without government relief. With relief, however, a first-best outcome is not achieved. Individuals purchase full insurance coverage against their exposure, so that relief and insurance completely compensate for any loss. But individuals are not induced to behave optimally. They are concerned only about how their behavior affects their insurance premiums, which, of course, are based on their exposure rather than total losses; as a result, the effect of risk-reducing behavior on the expected cost of government relief is ignored.
The article then considers the situation in which insurance companies cannot observe individuals' risk-reducing behavior. In this case, which involves moral hazard, individuals