Self-Protection and Insurance with Interdependencies

We study optimal investment in self-protection of insured individuals when they face interdependencies in the form of potential contamination from others. If individuals cannot coordinate their actions, then the positive externality of investing in self-protection implies that, in equilibrium, individuals underinvest in self-protection. Limiting insurance coverage through deductibles or selling “at-fault” insurance can partially internalize this externality and thereby improve individual and social welfare. ∗Muermann: The Wharton School of the University of Pennsylvania, 3620 Locust Walk, 3010 Steinberg-Dietrich Hall, Philadelphia, PA 19104, USA, email: [email protected] – Kunreuther: The Wharton School of the University of Pennsylvania, 3730 Walnut Street, 563 Jon M. Huntsman Hall, Philadelphia, PA, 19104, USA, email: [email protected]. We are grateful to Paul Kleindorfer and a referee for valuable comments. Support from NSF grant number CMS-0527598 and the Wharton Risk Management and Decision Processes Center is gratefully acknowledged.