Department of Economics, University of Kansas

Department of Economics, University of Illinois at Urbana- Champaign

June 1999

This paper analyzes risk-sharing arrangements between countries when there is uncertainty about the realization of a key performance variable. The realization of the performance variable is a countryís private information, and the cost of verifying performance differs across countries. We derive the conditions under which forming a coalition for risk sharing purposes dominates autarky when verification costs are borne by all members of the coalition. We also derive the optimal insurance contract for a coalition. On the one hand, risk sharing enables countries to smooth consumption. On the other hand, heterogeneous verification costs among countries generate a deadweight loss in consumption. In addition, when these costs are "publicly" borne by all members via a common pro rata share, this cost sharing introduces a negative externality into the optimal contracting problem, and results in moral hazard. We study a particular policy often used by multilateral agencies to address this problem known as "conditionality transfer." We show that this policy mitigates the negative externality problem inherent in problems with publicly borne, heterogeneous verification costs.

Key words: Multilateral Organizations, Contracts, Insurance and Verification.

JEL Classification: D8, F3.

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^* We are grateful to Donald Lien for helpful comments.