EXPORT INSURANCE SUBSIDISATION AND UNDISTORTED TRADE CREATION. Gerda Dewit University of Glasgow. September 1996

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1 EXPORT INSURANCE SUBSIDISATION AND UNDISTORTED TRADE CREATION by Gerda Dewt Unversty of Gasgow September 1996 Abstract: Trade actvtes nvovng uncertanty tend to be underdeveoped. Incompete or mssng nsurance markets often e at te bass of tese unexpoted trade opportuntes. We argue tat, under certan condtons, subsdsng a pubc nsurance system s te second-best pocy to remove ts neffcency. Te paper ustrates ts by concentratng on te rsk of defaut and offca export nsurance. Te WTO Subsdy Code expcty rues out export nsurance subsdsaton because suc a practce s beeved to dstort trade. We sow tat nsurance contracts can be desgned to prevent premum subsdes from dstortng competton. Wat s more, tey nduce trade creaton nstead. Ts form of trade creaton s partcuary reevant for deveopng countres, often reputed for a g rsk of defaut. JEL Cassfcaton: D8, F13, O19. Address for correspondence: Gerda Dewt, Department of Potca Economy, Unversty of Gasgow, Adam Smt Budng, Gasgow G1 8RT, UK; te:+44-(0) ; fax:+44-(0) e-ma: G.Dewt@socsc.ga.ac.uk

2 INTRODUCTION Due to ncompete nsurance markets, trade actvtes entang uncertanty tend to be underexpoted. Asymmetrc nformaton probems often form te bass for ts market faure. Ts paper focuses on te rsk of defaut, many faced by frms exportng to deveopng countres. St, we beeve te anayss to be reevant for any source of rsk affectng export decsons of rsk averse frms. In most ndustrased countres offca export agences provde nsurance aganst te rsk of defaut. Wat s more, emprca studes (Abraam, 199) pont out tat most of tese agences are operatng wt sustaned osses. Te WTO Subsdy Code expcty rues out ts form of export subsdsaton, dsmssng t as a trade dstortng practce. Yet, our anayss sows tat subsdsed export nsurance scemes need not aways ead to trade dstorton. On te contrary, tey may prevent t. Ts s te case f adverse seecton forms an mpedment to attanng frst-best nsurance contracts n te prvate market. We te noton of undstortng export nsurance subsdsaton may seem paradoxca, te more genera dea tat a more effcent aocaton of rsk tan te market outcome may be reaced by government nterventon s far from beng new. Eaton and Grossman (1985) consder te effect of uncertan terms of trade n a sma open economy were nsurance markets are ncompete. Tey argue tat trade pocy coud partay substtute for mssng nsurance markets. In oter words, trade nterventon may serve as a second-best mecansm for poong rsk. However, Dxt (1990) cams tat suc pocy prescrptons must be advocated wt cauton. Hs asserton rees on an argument of far comparson. Ts means tat te nformaton constrant causng te market faure soud be equay mposed on government pocy. Ony f te advsed pocy outperforms te market gven ts nformaton constrant, government nterventon may be justfed. Dxt concudes tat, nstead of usng te ncompeteness of nsurance markets as an assumpton, te source of te market faure soud ceary be dentfed. In ne wt ts reasonng we frst examne te export nsurance contracts provded by a perfecty compettve market and compare tose wt optma pubc nsurance poces. In te frst secton of te paper, some fgures on offca export nsurance are presented. In secton two, we start te forma anayss by budng a bencmark case wt symmetrc nformaton. Bascay, we concentrate on ow exports are affected by te terms of te avaabe nsurance poces. Adverse seecton s ntroduced n secton tree. Here, our attenton s drawn to te queston weter and to wat extent te nformaton asymmetry n te nsurance market as an mpact on nsured frms compettveness n te export market. Secton four formuates te nsurance probem for an offca export nsurer confronted wt te same nformaton probem as prvate companes. We argue tat a pubc nsurance agency can outperform te market n terms of effcency by grantng premum subsdes. Moreover, t s sown tat ts pocy guarantees undstorted trade. 1. SOME FIGURES ON EXPORT INSURANCE SUBSIDISATION Export credts aowng for defer of payment generate a rsk of defaut. More specfcay, te foregn mporter may defaut (part of ) te sum stpuated n te export 1

3 contract at te moment te credt term expres. In spte of te WTO s expct probton of export nsurance subsdsaton, t s a commony used practce n OECDcountres (Abraam (1990); Abraam, Couwenberg and Dewt (199); Dewt (1996)). Te WTO Subsdy Code defnes export nsurance subsdes as a sustaned postve dfference between cams pad and prema receved by offca export nsurance agences. Fgure 1 presents subsdy estmates for varous ndustrased economes durng te perod Atoug tere are some exceptons, most countres resort to a pocy of subsdsaton. Subsdy rates (.e., subsdes expressed as a percentage of nsured exports) are substanta and vary around 5%. Fgure 1: Average nternatona export nsurance subsdsaton (1988-9) Canada Portuga USA Fnand Japan Austra Sweden Begum UK Austraa Norway Germany Swtzerand Span Itay subsdy rate (%) cams-prema as a % of nsured exports Source: Dewt (1996), p.10. Fgure refects te sares of nsured contracts n tota exports for te countres seected. Gobay speakng, te sare of nsured contracts s too sma to ave a dstortng effect on overa nternatona competton. Japan and Austra form notabe exceptons to ts genera tendency wt frms nsurng up to 40 % and 0 % of ter exports respectvey. St, te amount of subsdes provded by natona nsurers may be cruca n estabsng or renforcng trade reatons wt tose (mosty underdeveoped) regons were te occurrence of defaut s common. Ts s confrmed by Fgure 3 wc sows a regona dsaggregaton of export nsurance contracts ssued by te Began offca export nsurer. Insured export contracts wt Afrcan and Asan destnatons comprse te buk of te poces, eac accountng for rougy 30 % of te tota poo of nsurance contracts.

4 Fgure : Insured contracts as a % of tota exports (1988-9) Fnand Canada USA Portuga Sweden Begum UK Austraa Norway Germany Swtzerand Span Itay Austra Japan nsured sare of exports (%) Source: Dewt (1996), p.10. Fgure 3: Regona dsaggregaton of Began export nsurance contracts ( ) Asa Sout Amerca Centra Amerca Afrca Centra & Eastern Europe Industrased countres Regona sare n nsured exports (%) Source: Dewt (1996), p

5 . TRADE AND EXPORT INSURANCE WITH SYMMETRIC INFORMATION: THE BENCHMARK CASE Consder a rsk averse domestc frm, exportng to regon were t faces a rsk of defaut. We derve te optma terms of export nsurance contracts coverng aganst suc rsk. In ts secton a bencmark framework wtout any nformaton asymmetres s but. We adopt te foowng set of assumptons. () Te export nsurance market s perfecty compettve. () Insurance agences are rsk neutra. () Te stocastc defaut varabe s captured by a regon-specfc dstrbuton. (v) Insurance companes know te defaut dstrbutons across export regons, and ndvdua defaut dstrbutons of exportng frms are assumed to be dentca. Terefore, no nformaton asymmetres are present n ts base framework. (v) Apart from beng known to te economc agents nvoved, defaut dstrbutons are aso market ndependent 1. (v) Frms are rsk averse and operate n a perfecty compettve product market. Ts ast assumpton removes te scope for trade nterventon based on strategc arguments. (v) In addton, we assume tat exportng frms are not servng ter domestc market. Margna costs of producton are ncreasng, aowng us to determne te frm s equbrum output. Te probem s anaysed n a one-perod two-stage game. Te premum of te nsurance pocy s set n te frst stage of te game by prvate export nsurance companes. In te second stage, a representatve rsk averse frm decdes on te terms of ts export contract as we as on te nsurance coverage t w take. Sovng te mode backwards, we start wt te frm s decsons n te ast stage..1. Te export decson of te rsk averse frm We formuate te exporter's optmsaton probem usng a mean-varance approac. Gven a certan degree of varabty, rsk averse exportng frms maxmse expected profts, or β max EV = EΠ var Π x, I (1) st.. I px EV s te frm s certanty-equvaent proft vauaton and β stands for te (constant) coeffcent of absoute rsk averson. Profts (Π ) are dstrbuted wt mean EΠ and varance var Π, equa to 1 EΠ = ( 1 Eλ) px + ( Eλ r) I x (a) var = ( px I) v (b) Π 1 Moreover, we gnore te possbty of background rsk as anaysed n Eeckoudt (199). Te more genera expected utty formuaton (as used n Dewt (1996)) s ere expcty specfed by a mean-varance type of proft vauaton functon. 4

6 p s te prce prevang n market we x s te frm s export voume to tat destnaton. Eλ and v denote te mean and varance of te stocastc payment-oss varabe λ (wt Prob{λ <0}=Prob{λ >1}=0), representng te sare of te export contract defauted at te expraton date. If te foregn mporter s unabe to pay (part of) te stpuated sum, te nsured exporter can cam payment from ts nsurance company. Hence, we refer to Eλ as te expected cam rate. I symboses te sum covered by nsurance and r s te premum rate,.e., te premum pad per currency unt nsured. Te premum ratng regme s unform. Ts means tat te premun rate s ndependent of ow muc coverage s purcased. Moreover, te covage eve s ndependent of te sze of te oss snce we assume tat frms cannot nfuence ts varabe. Te ast term n (a) stands for te producton cost functon, exbtng ncreasng margna costs. Te constrant n (1) refects te ega probton of takng more tan fu nsurance. Proposton 1: Wt symmetrc nformaton and exporters coosng nsurance coverage, te export voume of a rsk averse frm () s ndependent of te frm s atttude towards rsk as we as of te features of te defaut dstrbuton; ()s negatvey affected by te export nsurance premum rate. Proof: Frst order condtons for (1) wt respect to x and I are 3 ( 1 Eλ ) p x β( p x I ) pv + ϕ p = 0 (3a) ( Eλ r) + β( px I) v ϕ = 0 (3b) ϕ s te Lagrange mutper assocated wt te fu coverage constrant. Condtons (3a) and (3b) reduce to x = p ( 1 r) (4a) Eλ r I = mn px + ; px (4b) βv From (4a) t s cear tat te frm s optma export voume s ndependent of ts atttude to rsk as we as of te features of te defaut dstrbuton. We beng ndependent of te coverage taken for te contract, exports are determned by te nsurance premum rate. Accordng to (4b) exporters prefer parta coverage f a premum tax (r > Eλ ) s carged. A tax feeds back nto te quantty tey coose to export, wc w be ower tan te export voume of a rsk neutra frm (obtaned by settng β equa to zero n (3a)) 4. If export nsurance contracts are subsdsed, te frm woud ke to overnsure ts export contract. Subsdsaton occurs wen te premum rate s set beow te far rate,.e., te expected cam rate (r <Eλ ). In tat case te constrant becomes bndng 3 Evdenty, tese condtons ony od f export nsurance s offered at suffcenty attractve terms. Ts means tat prema soud not exceed a crtca rate at wc frms coose not to nsure ter contracts. Tecncay, te foowng partcpaton constrant soud not be voated EV( I > 0) EV( I = 0 ). Ts w be guaranteed by te prema set by te nsurance agences. 4 Ts separaton teorem was earer derved by Funatsu (1986). 5

7 (ϕ = Eλ - r >0) and I = px. Next, we turn to te frst stage, were nsurance agences determne premum rates... Optma export nsurance wt symmetrc nformaton Wt perfect competton n te export nsurance market, rsk neutra nsurance companes maxmse te objectve functon of a representatve exporter subject to ter budgetary break-even constrant. Snce te regon-specfc defaut dstrbutons are known and ndependent, te optmsaton probem for an export nsurance company offerng nsurance for exports to regon s gven by max EV r, ψ (5) st.. ( r Eλ ) I 0 wt ψ denotng te Lagrange mutper assocated wt te company s budget constrant. Frst order condtons to te probem n (5) are equa to ( 1+ ψ ) I + EV dx + EV di = 0 x I dr (6a) dr ( r Eλ) I = 0 (6b) From te second stage we know tat eter EV = EV =0(f ϕ x I = 0 ) or dx di = =0 dr dr (f ϕ > 0 ), ence ψ =1. Te optma premum ratng rue resutng from (6b) entas far premum ratng (r =Eλ ). Ts bencmark outcome s not surprsng. Snce tey ave te same nformaton about te rsk caracterstcs of te export contracts as te appcants and ave no bass for strategc nterventon, fercey competng rsk neutra nsurance companes carge te zero-proft premum rate. Ts mpes tat wt symmetrc nformaton rsk averse nsured frms export exacty te same voume as ter rsk neutra counterparts. Ceary, te nsurance poces provded by te market are Pareto-effcent, rung out any bass for state nterventon n te bencmark case of symmetrc nformaton. 3. TRADE AND EXPORT INSURANCE WITH ADVERSE SELECTION Suppose domestc exporters are no onger dentca n te sense tat tey are facng dfferent defaut dstrbutons, even toug ter customers are ocated n te same export market. Ts scenaro s far from beng unreastc snce domestc frms, beongng to dfferent ndustres, evdenty dea wt dfferent type of customers. Dependng on te nature of te product nvoved, some frms may be more dependent on rsky customers (.e., ndustres or ndvdua buyers caractersed by a ger defaut rsk) tan oters 5. More partcuary, te dstrbutons dverge n te sense tat tey ave dfferent means, we ter varances are assumed to be te same for te woe regon. 5 We focus on commerca rater tan on potca rsk. We te frst type of defaut s reated to an ndvdua mporter, te second type s reated to te mportng country as a woe. 6

8 Wen concudng rsky contracts, te frm, beng aware of te potenta nsovency of ts cent, as an ncentve to de te true rsk nature of te type of contracts t wants to nsurance. We tey soud be cassfed as gy rsky, te frm may msrepresent ts contracts to te export nsurance company as beng ow-rsk n order to beneft from a ower premum rate. In oter words, te company s confronted wt a probem of adverse seecton 6. Introducng a screenng devce n ts offered contracts s one way to tacke ts probem 7. More specfcay, te nsurer soud desgn a speca package of poces, contanng g- and ow-rsk contracts and nducng eac rsk category to seect te approprate contract. Te natura canddate for suc a sef-seectng varabe n export nsurance s te coverage. For smpcty, we ony dstngus between two rsk groups. One group (denoted by ) faces a g defaut rsk (Eλ ), we te oter one (symbosed by ) s confronted wt a reatvey ow expected payment-oss ( Eλ, and Eλ < Eλ ). Unke n te bencmark case, nsurance companes nk te premum rate for eac rsk category to a specfc coverage eve, tereby mpementng a non-near nsurance sceme. Te resutng equbrum set of nsurance contracts s cruca to te rsk averse frm's export decson, taken n te second stage of te game Te frm s export decson wt sef-seectng nsurance contracts Frms now ave to make ter export decsons gven te avaabe nsurance contracts, stpuatng a premum rate and assocated covered sum for eac rsk group. Hence, we reformuate te frm s objectve as k k β k max EV = EΠ var Π k =, (7) x k Te frst order condton wt respect to x k s k k k k ( 1 Eλ ) p x ( p x I ) pv β = 0 k =, (8) Hence, te optma export voume for rsk cass k to regon s equa to: k k k k 1 Eλ + βv I x = p k =, (9) 1+ βpv Ceary, te frm s export voume depends on ts atttude to rsk, te features of te regona defaut dstrbuton and te coverage avaabe for ts rsk category. Frms are nduced to export more f nsurance poces consst of ger coverage eves. At te same tme a cange n te premum rate s not transmtted nto exports under ts type of nsurance provson. 6 Te nature of ts probem of asymmetrc nformaton s totay dfferent from te probem of mora azard. Wereas frms can nfuence te probabty tat defaut occurs or te sze of te paymentoss by ts own actons wt mora azard (for an anayss of ts probem n export nsurance, we refer to Dewt (1996), Capter ), frms cannot affect tese factors wt adverse seecton. 7 It s generay beeved tat a screenng mode provdes te most natura nterpretaton of te adverse seecton probem n an nsurance context (Donne and Doerty, 199). Te concept of screenng refers to te fact tat unnformed agents,.e., prvate export nsurance agences n our case, move frst. 7

9 3.. Te optmsaton probem of an export nsurer wt Wson foresgt In te frst stage of te game, te nsurer as to set te terms of te nsurance contracts for eac rsk category. Te optma package of nsurance poces as to respect te agency's budget constrant on te one and, and ncorporate a sef-seecton mecansm on te oter and. In oter words, nsurance contracts for g- and ow-rsk groups ave to be offered at terms wc guarantee tat exporters seect te pocy desgned for ter own rsk category. Tose condtons are referred to as te ncentve compatbty constrants: EV ( r, I ) EV ( r, I ) (10a) EV ( r, I ) EV ( r, I ) (10b) Formuatng te optmsaton probem n a perfecty compettve nsurance market wen adverse seecton s present, s not trva. In partcuar, t requres certan assumptons about te type of antcpatory beavour among competng nsurance agences. We assume tat te nsurance companes possess Wson foresgt. Ts noton refers to an aternatve non-nas type of equbrum. Actuay, we use a modfed verson of te Wson equbrum (Myazak (1977), Spence (1978)), abeed as te Myazak- Wson (MW) equbrum 8. Ts type of equbrum s caractersed by two mportant eements. Frst, t ony requres tat te contract set as a woe respects te nsurer's budget constrant. Ts quafcaton perfecty compes wt te WTO Subsdy Code wc dentfes a far provson of export nsurance wt an overa zero-oss budgetary poston. Transated nto ndvdua poces, ts mpes tat te agency may ose on some contracts, and make a proft on oters. Second, ts equbrum concept s n some sense ess myopc tan te Nas aternatve, as nsurance agences antcpate te reacton of ter (potenta) compettors wen decdng wc contracts to offer. In addton, Crocker and Snow (1985) ave proven tat te MW-equbrum yeds te second-best outcome n a market were a probem of adverse seecton prevas. Snce we bud ts framework to compare t wt te optma contracts offered by a pubc nsurance company, we wtod te prvate market outcome wc renders te best rsk aocaton for a nsured frms. Ts way, te prvate nsurance market outcome provdes a ower bound for te potenta wefare mprovement a pubc nsurer possby coud engender. Myazak (1977) estabsed tat, f te ow-rsk cass s suffcenty arge, nsurance agences possessng Wson-foresgt act as f tey maxmse te objectve functon of te ow-rsk type of agents. In oter words, maxmsaton of te objectve of te g- 8 Ts equbrum concept s defned by Crocker and Snow (1985; p. 13) as: "A Myazak-Wson (MW) equbrum s a set of contract portfoos suc tat wen consumers coose contracts to maxmse expected utty () eac portfoo earns non-negatve proft and () tere s no portfoo outsde te equbrum set tat, f offered, woud earn a non-negatve proft even after te unproftabe portfoos n te orgna set ave been wtdrawn." 8

10 rsk group s ten automatcay mped. St, f g-rsk frms account for a sare n tota poces exceedng a crtca vaue, a dfferent nsurance regme prevas. Here, we dstngus between tese two cases n our dscusson of optma export nsurance provson Optma export nsurance wen te g-rsk group s sma Frst, we cover te case were te sare of g-rsk contracts n te tota poo of poces s reatvey ow 9. Ten, te nsurer's optmsaton probem s gven by: max r, I k =, st.. () α( r Eλ) I + α ( r Eλ) I 0 ( ) EV ( r, I ) EV ( r, I ) (11) EV ( r, I ) EV ( r, I ) k k ( ) I px α and α are te proportons of ow- and g-rsk contracts n tota nsured exports respectvey. Tese are known by a partcpants n te nsurance market. Snce te ncentve compatbty constrant for te ow-rsk group and te fu coverage constrants are not necessary bndng, we frst sove te probem wen te Lagrange mutpers connected to tese constrants are zero. Maxmsng (11) yeds te foowng set of frst order condtons ( ψα χ) I =0 (1a) ( 1+ ψα + χ) I = 0 (1b) ψα ( r Eλ) + χ[ Eλ r + β( px I )] =0 (1c) Eλ r + β( px I ) v + ψ α ( r Eλ) dx χ Eλ r + β( px I ) v + EV ( r, I ) x di 0 (1d) α( r Eλ) I + α ( r Eλ) I =0 (1e) 1 ( 1 Eλ) px + ( Eλ r ) I ( x ) = ( 1 Eλ) px 1 β + ( Eλ r ) I ( x) ( px I ) v (1f) ψ and χ symbose te Lagrange mutpers assocated wt te budget constrant and te ncentve compatbty condton respectvey. From (1a) and (1b) we cacuate te vaues of tese mutpers (ψ =1, χ =α ). Furtermore, EV ( r, I ) = ( 1 Eλ ) p x βp v ( p x I ) and te export decson n te frst stage (expresson (9)) mpes dx di x βpv = 1 + βpv. Knowng ts, rearrangng 9 Te term "reatvey ow " refers to te condton tat te proporton of g- to ow-rsk contracts soud not exceed a crtca vaue, wc w be determned ater. 9

11 (1c) and (1d) yed te coverage specfed n eac rsk group s export nsurance pocy I = p x = p ( 1 Eλ ) (13a) α Eλ Eλ I = p ( 1 Eλ) (13b) α βv So, te covered amount specfed n te g-rsk contract s te same as woud preva under a competey symmetrc nformaton set-up. Te ow-rsk contract, owever, merey entas parta coverage ( I < p ( 1 Eλ ) ). Hence, ts rsk cass s sadded wt te oad of te nformaton asymmetry. Te unnsured part of te ow-rsk contract crucay depends on tree eements. Frst, te gap between expected payment-osses for bot rsk groups nfuences te uncovered part of te export contract n a postve way. A wde payment-oss gap refects a arger dfference n rsk caracter of bot rsk types, tereby renderng te adverse seecton probem more pronounced, as te cost of mstakng a g-rsk frm for a ow-rsk one s more substanta. Ts s refected n a curtaed coverage for ow-rsk frms, wc abates te ncentve for g-rsk exporters to nappropratey coose te ow-rsk contract. Second, te unnsured part of te ow-rsk contract s sma as frms are more rsk averse. Hg-rsk frms ten tend to ave strong preferences for fu coverage contracts, aowng te nsurer to offer a more attractve pocy to te ow-rsk group. Trd, te effect of te payment-oss dfferenta on te unnsured part of te ow-rsk contract s weged by te rato of g- to ow-rsk contracts ( α ). As ts rato α ncreases, te extent to wc te adverse seecton probem affects te market s magnfed, nducng te nsurer to enarge te unnsured part of te ow-rsk export contract 10. Furtermore, (13a) and (13b) ndcate tat te fu coverage constrant s not bndng for any combnaton of parameter vaues. By sovng expressons (1e) and (1f) we obtan te optma premum ratng scedue α ( r Eλ) I r = Eλ (13c) α I r = αeλ + α Eλ 1 β p( 1 Eλ)( x x ) ( x) ( x ) ( px I ) v (13d) + α I Te ow-rsk group s mpcty taxed for te nformaton asymmetry n te nsurance market ( r Eλ ). St, ts tax eement decnes as te ow-rsk contract nvoves ess coverage. Conversey, te g-rsk premum s ess tan te cam payments expected from te underyng contract ( r < Eλ ). Actuay, te premum "tax" owrsk nsured frms pay s transferred to ter g-rsk counterparts. So, tere s some 10 It soud be noted tat tere s no pont n forcng te g-rsk type away from a fu coverage pocy, snce ts woud aso deterorate te terms of te ow-rsk nsurance contract n order to preserve te ncentve compatbe coverage gap. 10

12 scope for mpct cross-"subsdsaton", n te sense tat g-rsk poces are carged a premum wc s -actuaray speakng- too ow, at te expense of te ow-rsk frms coverng te dfference. Te atter accept to pay ts transfer snce ts aows te agency to offer tem a pocy wt a ger degree of coverage. Atoug most of te tme ts second-best set of poces enta separatng contracts (.e., dfferent poces for dfferent rsk groups), a poong equbrum ( I = I = I, r = r = r ) may preva. From (13a) and (13b) we cacuate tat ts occurs for α α = βpv 11,1. Te wngness to cross-subsdse on te part of te ow-rsk nsured frms crucay depends on te fact tat tey suffcenty outnumber g-rsk frms. If not, we end up n anoter pocy regme wc s dscussed next Optma export nsurance wen te g-rsk group s arge If te proporton of te ow- to te g-rsk group s ower tan te crtca rato, maxmsng ow-rsk certanty-equvaent profts under te earer specfed constrants n (11) s no onger optma. In tat case, te ncentve compatbty constrant owers te covered amount and assocated premum so muc tat te ow-rsk premum becomes even smaer tan te actuara ow-rsk expected defaut. Hence, accordng to te premum scedue formuated n (13c) and (13d), te g-rsk premum exceeds te reated expected cams. Ts means tat maxmum certanty-equvaent profts are no onger guaranteed for te g-rsk category. To prevent ts from appenng, anoter constrant as to be added: * EV ( r, I ) max{ EV ( I ) ( Eλ r ) I } (14) I * Ts condton ensures tat te varabty of g-rsk contracts s mnmsed. In oter words, te g-rsk pocy as to mpy certanty-equvaent profts wc are at east equa to expected profts (net of te dfference between expected cams and te carged premum) generated by a fu coverage g-rsk contract. Ts s te contract requred by te rgt and sde of condton (14). If α α constrant w be bndng. s suffcenty substanta, ts In tat case, optmsng te probem stated n (11) wt te addtona constrant n (14) repaces frst order condtons (1a) and (1c) by expressons (15a) and (15b), and yeds an addtona condton (15c) ( ψα χ ϑ) I =0 (15a) ψα ( r Eλ) + ( χ + ϑ) Eλ r + β( p x I ) =0 (15b) 11 St, te condton tat βp v soud be smaer tan te crtca rato of g- to ow-rsk frms must od. 1 In spte of te premum transfer tey pay to g-rsk nsured frms, t can be sown tat ow-rsk exporters aways prefer te ow-rsk pocy f px I >0. Hence, te ow-rsk ncentve compatbty constrant s not bndng. 11

13 1 1 ( 1 Eλ) px + ( Eλ r ) I ( x ) = p ( 1 Eλ ) (15c) wt ϑ symbosng te Lagrange mutper assocated wt (14). From (15a) and (1b) we know ϑ + χ = αψ and χ = 1 ψ α. Expressons (15c) and (1e) now determne premum rates as k k r = Eλ k =, (16) In contrast to te case were tey were reatvey abundant, ow-rsk exporters are now very reuctant to provde an mpct premum transfer to ter g-rsk domestc compettors. Ts reuctance s mrrorred n te premum scedue, wc now nvoves "far" premum ratng for bot rsk casses. Te correspondng coverage amounts are obtaned by sovng (15b) and (1d) for I and I : I = p x = p ( 1 Eλ ) (16b) Eλ Eλ I = p ( 1 Eλ) + βv Eλ Eλ βv + p ( 1 Eλ) p ( Eλ Eλ) βv + ( I ) (16c) Agan, a fu coverage contract s offered to te g-rsk group, we ony a parta coverage pocy s avaabe to te ow-rsk category. Yet, certanty-equvaent profts are ower under ts dstrbuton of g- to ow-rsk exporters compared to tose n te prevous stuaton. Compared to te symmetrc nformaton bencmark case, owrsk nsured frms are worse off, but st reacng ger certanty-equvaent profts tan wtout nsurance coverage. Snce te premum s set at te "far" eve, ow-rsk frms w aways prefer some coverage to none at a 13. Note tat te derved MWequbrum now concdes wt te Nas-equbrum. Te crtca proporton of g- to ow-rsk frms pns down te pont of te pocyregme swtc. At ts pont, bot maxmsaton procedures soud yed te same optma set of poces. So, by ettng te ow-rsk covered amounts derved n (13b) and (16c) be equa to eac oter, we obtan ts partcuar crtca vaue, α α α α Eλ Eλ βv p Eλ p * + ( 1 ) βv = Eλ Eλ ( Eλ Eλ) βv * : + ( I ) 1 (17) 3.3. Te effects of adverse seecton n te nsurance market on export performance n rsky markets 13 Moreover, t can be sown tat ow-rsk frms strcty prefer te ow-rsk pocy to te g-rsk one f p p ( 1 Eλ)( Eλ Eλ) p ( Eλ Eλ) ( 1 Eλ) + > p ( 1 Eλ ) + βv βv 0< Eλ < Eλ < 1, ts s aways true. 1. Snce

14 Snce te nsurance terms of te avaabe poces are dfferent from tose prevang under symmetrc nformaton, te frm's export voume w dffer as we. In ts secton we dscuss te effects of adverse seecton n te nsurance market on te frm's export performance. Effcent export nsurance soud nduce rsk averse frms to export as muc as ter rsk neutra domestc compettors. We ave sown tat ts s te case wt nsurance poces offered under symmetrc nformaton. Suppose tere are dfferent rsk categores among exporters, yet frms are unabe to concea ter true rsk type. In oter words, te payment beavour of foregn mporters s pubcy known. Hence, premum rates are far for a rsk groups mpyng tat rsk averse and rsk neutra frms of rsk type k export te same quanttes, or k k x = x k =, β> 0 β= 0 k k Aso, rsky export ( x λ k >0 ) devates more from te safe voume ( x λ k p = 0 = ) f te expected defaut rate s g k k k x x = p Eλ k =, k k λ = 0 λ> 0 Moreover, wt far prema for a contracts and frms coosng compete coverage, a ow-rsk frm aways exports more tan a g-rsk one, or x x = p( Eλ Eλ) So, te dfference between te export voumes of te two rsk types bascay depends on te gap between te respectve average cam rates. Gobay speakng, te aocaton of products across foregn mporters s perfecty n ne wt sound rsk aocaton. Now we sow tat ts s no onger true f probems of adverse seecton arse n te export nsurance market. Proposton :Insurance poces preventng adverse seecton n te export nsurance market () nduce rsk averse ow-rsk frms to export ess tan rsk neutra exporters of te same rsk type. ()nduce g-rsk frms to export as muc as rsk neutra exporters of te same rsk type. Proof : Substtutng te expressons for I and I wen te rato of g- to ow-rsk contracts s suffcenty ow (13a) and (13b) nto (9) yeds optma export quanttes for eac rsk group: x β> 0= p( 1 Eλ) (17a) α x β> 0= p( 1 Eλ) p ( Eλ E λ) α (17b) Aternatvey, after puggng te vaues for I and I wen te proporton of g- to ow-rsk contracts s reatvey g ((16b) and (16c)) nto (9), we obtan x β> 0= p( 1 Eλ) (18a) 13

15 x p E p E E = ( λ λ β λ) + > βpv Eλ Eλ p ( Eλ Eλ) + p ( Eλ) ( I ) βv (18b) 1 + βv pβv 1+ βpv Export voumes of rsk neutra frms of te respectve rsk casses are gven by x β= 0= p( 1 Eλ) (19a) x β= 0= p( 1 Eλ) (19b) Hence, we ave x β> 0 x β= 0= 0 and x β> 0 x β= 0< 0. We te exported amount of te g-rsk category remans unaffected by te presence of adverse seecton, ow-rsk exporters experence a drop n ter exports compared to te symmetrc nformaton case (ts s true for bot te soutons under adverse seecton). Ts oss n compettveness s more dramatc as te gap between expected payment-osses wdens and te proporton of g- to ow-rsk contracts rses. Furtermore, te parta coverage contract for te ow-rsk group dstorts competton between domestc g- and ow-rsk frms snce x β> 0 x β> 0< x β= 0 x β= 0. Te natura compettve advantage ow-rsk frms possess srnks as te rato of g- to ow-rsk exporters n te domestc market rses. Te case were a poong equbrum prevas n te nsurance market deserves speca attenton. Atoug bot g- and ow-rsk frms purcase te same (sngy offered) pocy, tey st dffer n terms of export performance, even toug ow-rsk exports are drastcay reduced. Wat s more, for specfc parameter vaues (.e., for α * α > > 1+ βpv ), te nsurance α α poces offered may nduce ow-rsk frms to export even ess tan g-rsk ones, or x β> 0< x β> 0. Suc a set of nsurance poces generates a rsk-reversed rankng n export performance. Tanks to te nformaton asymmetry n te nsurance market, g-rsk frms are reatvey more compettve n te targeted market tan ter owrsk rvas. Te provson of export nsurance eads to neutra trade creaton n te absence of nformaton asymmetres n te nsurance market. Ten, underdeveoped trade reatons wt regons reputedy caractersed by a rsk of defaut w expand. Domestc frms concudng rsky deas enter te envsaged regon n far competton wt ter domestc and foregn rvas. Moreover, te sare of rsky contracts n tota exports to tat partcuar market as reaced ts optma vaue. In addton, wt oca frms n te rsky market facng foregn competton, consumer surpus n te foregn market w ncrease. Yet, once adverse seecton enters nto te pcture, te avaabty of nsurance contracts n te prvate market nevtaby creates a competton bas dsfavourng ow-rsk domestc exporters. Evdenty, te set of poces offered by nsurers and te export voumes cosen by frms affect te atter s certanty-equvaent profts. 14

16 Proposton 3: Insurance poces preventng adverse seecton n te export nsurance market causes certanty-equvaent profts of g-rsk nsured frms to be at east as g compared to te symmetrc nformaton framework, we certanty-equvaent profts for ow-rsk frms are unambguousy ower tan n te symmetrc nformaton bencmark. Proof : Snce, for g-rsk frms, coverage eves and export quanttes are te same weter adverse seecton s present or not, and r Eλ wt adverse seecton, we know tat adverse seecton symmetrc nf ormaton ( EV ) ( EV ) Furtermore, we know tat, at far premum ratng and at any x, fu coverage s strcty preferred to parta coverage, mpyng EV ( I = p x ) + > EV ( I < p x ) + x r E, = λ x, r= Eλ Hence, snce ony parta coverage poces are avaabe for ow-rsk frms (at r Eλ ) wen tere s a probem of adverse seecton, we ave adverse seecton symmetrc nf ormaton ( EV ) < ( EV ) Te subsequent secton examnes weter a snge pubc nsurer can prevent ts negatve sde-effect of export nsurance, tereby attunng ts rsk reducton mecansm to ts roe as an nstrument of pure trade creaton. 4. TRADE AND PUBLIC EXPORT INSURANCE Here we concentrate on te queston weter t s possbe for a pubc nsurance agency to (party) reeve ow-rsk frms from te burden of te nformaton asymmetry tey are encumbered wt? For te probem formuaton of a snge pubc nsurance company, we adopt te tradtona type of objectve functon of a government nsttuton. In ts partcuar case, te offca export nsurer maxmses certanty-equvaent profts of rsk averse frms facng a rsk of defaut, corrected for te subsdy costs. In oter words, te pubc agency does not face a ard budget constrant. Because no frm soud be reatvey dsadvantaged by te provson of nsurance, te pubc nsurer maxmses net-benefts from nsurance wt respect to coverage for eac rsk category: k k max EV ES I k =, (0) Te frst order condton for coverage s ten k k k k k k Eλ r + β( px I ) v ( Eλ r ) = 0 k =, (1) mpyng k k I = px k =, () As opposed to te ow-rsk contract tat woud be supped n a prvate nsurance market, a pubc agency soud provde fu coverage for bot groups' export contracts. Yet, ts does not mpy tat te resutng set of nsurance contracts squeezes down to 15

17 a poong equbrum, were te same contract s desgned for a rsk casses. Bot rsk types obtan fu coverage, but te amount of coverage stpuated n te contract ceary dffers, te dfference beng fuy determned by te wedge between expected payment-osses of te dfferent rsk categores ( Eλ - Eλ ). Aternatvey, as te owrsk group faces a ower expected payment-oss tan ts g-rsk compettors, ts optma export quantty s ger, n turn mpyng tat te optma nsurance contract as to provde a ger coverage as we ( I > I ). Te correspondng prema set s determned n ne wt te ncentve compatbty constrants, gven earer n (10a) and (10b). From te defnton of te utty functon and from te optma coverage formua (), te ncentve compatbty condtons reduce to: I 1 ( x) ( x ) I 1 ( x) ( x ) r 1 ( 1 r ) and r r 1 ( 1 ). I I I I Te ony premum prcng sceme wc satsfes bot condtons s terefore gven by: I 1 ( x) ( x ) r = 1 ( 1 r ) (3) I I So, te premum gap s determned by te dfference n coverage on te one and and by te wedge n producton costs (.e., te second term of expresson (3)) on te oter and. Te optma premum wedge as to be nterpreted as a trade-off between te reatve benefts of te provded coverage to rsk averse exporters, and te dfference n producton costs tey nduce. Atoug te ow-rsk group receves a ger eve of coverage, and terefore as to be carged a ger premum, t aso ncurs a ger cost of producton, precsey because te ger coverage encourages ts rsk cass to export more. Te atter effect narrows down te premum dfference. Note tat te ow-rsk premum soud not be set too g snce ten ow-rsk exporters w prefer g-rsk contracts (.e., te ow-rsk ncentve compatbty constrant now becomes bndng). Expresson (3) does, owever, not ndcate at wat precse eves prema ave to be set. If te pubc agency taxes ow-rsk poces, prvate nsurers may become actve, ony offerng ow-rsk contracts. Hence, some ow-rsk frms w take nsurance n te prvate market, eavng a g-rsk contracts to be nsured by te pubc agency. To prevent ts from appenng, te pubc nsurer sets ow-rsk prema at te zero-proft eve,.e., a far premum (r = Eλ I ). By pnnng down te ow-rsk premum, te premum scedue specfed n (3) aso aows us to cacuate te premum for te g-rsk category. After avng derved prema for bot rsk groups, t s stragtforward to cacuate te subsdes ncorporated n ts menu of nsurance poces for exports to regon : ES = n( Eλ r ) I + n ( Eλ r ) I (4) wt n k representng te number of rsk-k contracts (or frms) n te tota poo of underwrtten poces. Havng substtuted te optma vaues for I k and r k nto expresson (4), we obtan 1 ES = n p( 1 Eλ) p( 1 Eλ ) > 0 (5) Ts resut ceary ndcates tat te presence of adverse seecton n te nsurance market provdes a ratonae for a pubc nsurer to subsdse ts export nsurance 16

18 scemes. Wat s more, te optma amount of subsdes augments as te number of g-rsk contracts ncreases and te gap between expected payment-osses of te rsk groups wdens. Intutvey, ts s perfecty reasonabe as te negatve mpact of te asymmetrc nformaton s magnfed f te features of te rsk groups become more pronounced, and f te number of (g-rsk) frms wc beneft from ts second-best word ncreases. How effcent s ts outcome compared to te equbrum tat woud be attaned n a perfecty compettve prvate export nsurance market? Proposton 4 : Wt adverse seecton, te terms of nsurance poces set by a pubc nsurer, maxmsng certanty-equvaent profts of nsured exporters net of subsdy costs, are reated to te prvate market outcome n te foowng way: () x prvate x pubc, x prvate = x pubc ; () EV k (r k, I k ) pubc EV k (r k, I k ) prvate, k=,. Proof : From expressons (13c), (13d), (16a), (3) and (5), we know tat r k prvate r k pubc and from (13a),(13b), (16b), (16c) and (), t s cear tat I k prvate I k pubc. Hence, () s proven. Moreover, snce I prvate I pubc and I prvate = I pubc, we know from expresson (9) tat () x prvate x pubc and x prvate = x pubc. Summarsng, n te prvate nsurance market, te ow-rsk export group woud ony be offered a parta nsurance contract, generatng ow-rsk certanty-equvaent profts wc are sgnfcanty ower compared to a stuaton were nsurance s provded by a snge offca export nsurer. Ts reducton n certanty-equvaent profts for te owrsk cass s especay drastc f g-rsk contracts are abundant compared to ow-rsk ones. Wt pubc nsurance, ts market faure s transated n subsdsaton. Hence, we te cost of asymmetrc nformaton s ncurred by te ow-rsk exportng frms n te case of prvate nsurance, t s now entrey transferred to te pubc nsurer. Second, g-rsk exporters aso gan from te provson of export nsurance by a pubc nsurance agency as opposed to te market, n te form of a ger premum subsdy. Atoug te prvate market outcome mpes tat tey are cross-subsdsed by ow-rsk frms (provded tat te atter are suffcenty abundant), te g-rsk premum subsdy requred to nduce frms to coose te approprate contract s ger under te pubc nsurance system. Snce te pubc ow-rsk nsurance contract s more attractve tan te correspondng prvate one, preventng te g-rsk exporters from coosng ts pocy as to be assocated wt an even ower g-rsk premum. Proposton 5: Wt pubc nsurance contracts preventng adverse seecton () rsk averse exporters export as muc as under rsk neutraty; ()certanty-equvaent profts are equa for a rsk categores. Proof: k pubc k Wen substtutng () n (9) we obtan () x = x, k =, β> 0 β= 0. 17

19 Gven (9) and (), puggng (5) nto te certanty-equvaent functon of te g-rsk 1 1 group yeds EV = p ( 1 Eλ) = px( 1 Eλ ) ( x) = EV. Hence, () EV = EV = EV. An mportant advantage of tese nsurance scemes es n te fact tat bot domestc frms and foregn consumers beneft from t. Frst, te reatve export performance of domestc ow-rsk exporters versus g-rsk frms s no onger armed. Meanwe, te gven export nsurance subsdes are of te ump sum type, mpyng tat export quanttes reman unaffected by te premum subsdes (see expresson (9)). Te atter ony ncrease certanty-equvaent proft ncome n a drect way. Te reason wy a pubc nsurance company can provde more effcent poces tan te prvate sector many nges on te fact tat tere s ony a soft budget constrant for te pubc agency (see expresson (0)). Te ssue of fnancng te offca agency s actvtes, owever, rses beyond te scope of ts paper. Second, more goods from ndustrased countres are now traded wt deveopng countres. If te domestc economy s mportant enoug n te mportng country s trade reatons, consumers n te rsky market may beneft from a consderabe decrease n prces of mported goods. CONCLUSION In spte of te expct probton of export nsurance subsdsaton by te WTO Subsdy Code, emprca studes revea tat severa ndustrased economes recur to ts practce. We te WTO s poston s based on a concern for trade dstorton caused by suc subsdes, we cam tat under specfc crcumstances te atter may even prevent compettve dstortons and ead to unbased trade creaton nstead. More partcuary, te vadty of ts statement rests on two condtons. Frst, te offca nsurance agency must face a probem of adverse seecton. Second, te terms of nsurance contracts must be determned by a non-near premum ratng sceme. Te benefts of ts type of nsurance are cear. Premum rates are codetermned wt coverage eves wc are fxed for a rsk categores. Hence, a premum subsdy merey consttutes a ump sum transfer from te agency s budget to nsured exporters wtout cangng te voume of trade. As a resut trade reatons between domestc and foregn frms competng n te envsaged market reman undstorted. At te same tme, te export performance of ow-rsk domestc exporters s not armed by te nformaton asymmetry as woud be te case wt prvate sector export nsurance. Hence, under tese condtons export nsurance subsdes ensure tat trade reatons wt markets caractersed by a rsk of defaut, ke most poor economes, are fuy deveoped. One mtaton of te paper s te negect of mora azard. Because te nature of optma nsurance contracts under ts type of nformaton asymmetry dffers substantay from te poces dscussed ere, we ave not ncuded ts ssue nto our anayss. Yet, ts does not ater our man concuson tat te current reguaton of 18

20 export nsurance subsdes reveas a ack of nsgt nto te specfc features of nsurance as a trade pocy nstrument. Probtng export nsurance subsdsaton soud be condtona on te type of nsurance poces provded. Wt a system of unform premum ratng eavng frms free n ter coverage coce, subsdes unavodaby ead to trade dstorton and soud terefore rgtfuy be restrcted. Yet, suc a restrcton w mpede te deveopment of trade reatons wt rsky markets f offca export nsurance s provded usng non-near premum ratng to avod adverse seecton. 19

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