Can environmental insurance succeed where other strategies fail? The case of underground storage tanks.

Private risk reduction will be socially efficient only when firms are liable for all the damage that they cause. We find that environmental insurance can achieve social efficiency even when two traditional policy instruments--ex post fines and risk management mandates with ex ante fines--do not. Inefficiency occurs with ex post fines, when small firms declare bankruptcy and escape their liabilities, limiting the incentives from this policy tool. Firms ignore mandates to implement efficient risk management because regulatory agencies do not have sufficient resources to monitor every firm. The evolution of the U.S. Environmental Protection Agency's and states' underground storage tank programs suggests that mandating environmental insurance can address inefficiency due to small firms declaring bankruptcy. Comparing insurance mandates to risk management mandates, the burden on a regulator is lower if all it has to do is to confirm that the firm has insurance rather than that the firm has actually, and effectively, implemented required management practices. For underground storage tanks, we show that insurance lowered toxic releases.