Insurance against disaster: public or private?

In the last two days we've had the announcement of a program to buy commercial insurance against drought in Ethiopia, and the launch of the new UN emergency fund.

New York Times: Aid Group Takes Out Insurance on Drought in Ethiopia

In a pilot project that could someday transform the world's approach to disaster emergencies, the World Food Program has taken out an insurance policy that will pay it should Ethiopia's notoriously fickle rains fail this year. The policy's creators are calling it the first natural disaster insurance coverage for an international aid agency .

The UN has launched a $500m (£288m) emergency fund to speed up the handout of money for humanitarian disasters. ... But worldwide responses to the fund have been muted - with only a quarter of the amount needed raised so far, of which a third has come from the UK.

UK International Development Secretary Hilary Benn described the world's reaction to disasters as similar to that of a fire brigade having to go round with a collecting tin to raise funds before it can put out fires.

In many circumstances, proposals to harness private sector energy, expertise and resources to solve problems of global poverty would be welcome (see, for example, our work on creating incentives for pharmaceutical companies to invest in vaccines).  But we should not have knee-jerk ideological preferences for either the public or the private sector.

In the case of insurance against natural catastrophes, economics theory points towards maintaining a single, large, international fund.  Most Governments self-insure because they face a large and diverse set of risks, and so makes sense for them to deal with the costs as they arise themselves, rather than pay private investors to bear those risks instead.  The private sector has to be compensated for taking individual risks, and for the cost consequences of both adverse selection and moral hazard. On the same logic, the international community faces a large and diverse set of risks from the consequences of natural disasters, and should self-insure rather than pay to transfer individual risks to the private sector. 

But as we see from the story of the UN Fund so far, there are considerable bureaucratic obstacles to international cooperation that this requires.  As UK Development Secretary Hillary Benn rightly points out, when the disaster occurs, there is no time to raise funds to pay for a response.  But it is very difficult to persuade donors to agree burden sharing arrangements and to make contributions to a fund for theoretical future disasters.  As a result, the proposed disaster fund is having difficulty raising the funds it needs.

The decision to establish a fund to insure Ethiopia against famine is not, as it may first appear, a welcome sign of new entrepreneurial thinking among aid agencies.  It is a measure of how the international system is failing.  The market will do it, at a price.  This insurance is going to work out quite expensive, though it is hoped that it will lead the way for a bigger and cheaper market.  But the international system could self insure much more cheaply.  That it is unable to do so, and will have to pay more to the private sector, is a failure of international coordination and a bureaucracy. The price that will be paid for private insurance is a measure of the cost of those failures of international coordination; and it will be paid for with money that would otherwise be used to help the poor.