Risk-based Pricing and Risk-reducing Effort: Does the Private Insurance Market Reduce Environmental Accidents?

This paper examines whether risk-based pricing promotes risk-reducing effort. Such mechanisms are common in private insurance markets, but are rarely incorporated in government assurance programs. We analyze accidental underground fuel tank leaks—a source of environmental damage to water supplies—over a fourteen-year period, using disaggregate (facility-level) data and policy variation in financing the cleanup of leaking tanks over time. The data suggest that eliminating a state-level government assurance program and switching to private insurance markets to finance cleanups reduced the frequency of costly underground fuel storage tanks leaks by more than 20 percent. This corresponds to more than 3,000 avoided fuel-tank release accidents over eight years in one state alone, a benefit in avoided cleanup costs and environmental harm exceeding $400 million. These benefits arise because private insurers mitigate moral hazard by providing financial incentives for tank owners to close, replace or upgrade leak-prone tanks prior to accidents that require costly cleanup. *Acknowledgements. We thank Carol Amend (US Environmental Protection Agency), Mark Barolo, William Foskett, Paul Miller, Sammy Ng, and Jerry Parker (US EPA, Office of Underground Storage Tanks), Jan Spoor (Illinois Office of the State Fire Marshall), Jeff Tanner and Kevin Wieber (Michigan Department of Environmental Quality), and Michele Schroeder (Zurich Company N.A.) for data provision and many insightful comments. We also thank seminar participants at The Wharton School and the Erb Institute Colloquium for useful suggestions. This project received financial support from the Wharton Risk Management and Decision Processes Center and the Russell Ackoff Award at the University of Pennsylvania.