National Adversity: Managing Insurance and Protection

This paper concerns self-insurance and self-protection that countries may implement at a national level in pursuit of their security. The distinctions self-insurance, self-protection, and market insurance were first made by Ehrlich and Becker (1972). Nevertheless, extension of their models to international security where market insurance for entire countries is usually unavailable is surprisingly sparse. We show that, in the absence of market insurance, self-insurance alone raises important new issues as to the definition of "fair pricing" and as to the relations between pricing, optimization, risk aversion, and inferiority that are significantly different from standard, conventional market analysis. We also discover a hitherto unrecognized tendency for misallocation between selfprotection and self- insurance when both are available and considered together. Because of external effects running from self- protection to self-insurance, governments trying to find the right balance face incentives that encourage extreme, self-inflicted moral hazard, to the detriment of self-protection. Moreover, rather innocuous assumptions concerning countries' preferences lead to pervasive goods inferiority for both insurance and protection. Consequently, unlike the conventional wisdom in the economic theory of alliances with its neat interior Nash-solutions, we show when "defense" or "security" is disaggregated into more realistic categories such as protection and insurance that instabilities and corner solutions will be the conventional standard. The resulting perverse incentives that we discover point to conflicts and other difficulties among agents trying to cooperate in their management insurance and protection must overcome. Moreover the analysis implies that the paradigm Olson-Zeckhauser model (1966) model for alliance allocative behavior was fundamentally insufficient for the problem it was designed to address.