Introduction


   Insurance plays a vital role in America's economy by helping households and businesses manage risks. Individuals purchase insurance so they can sleep well at night; they gain comfort from the knowledge that they and their families are protected from some of the adverse effects of future events beyond their control. Businesses purchase insurance for much the same reason. It allows them to reduce the uncertainty associated with future costs and revenues, which enables them to plan for the future more effectively. Today, one can purchase insurance protection against a myriad of economic hazards, from poor health to motor vehicle accidents to legal liability to lightning strikes.

   Insuring economic losses arising from large-scale natural and manmade catastrophes such as earthquakes, hurricanes, and terrorist attacks poses special challenges for the insurance industry and for Federal and State governments. This chapter examines the economics of catastrophe risk insurance. It draws the following main conclusions.

   1. In insurance markets, as in other markets, prices affect the way people weigh costs and benefits. Insurance prices that are artificially low can discourage people from adequately protecting against future losses. For example, subsidized property insurance prices may stimulate excessive building in high-risk areas, potentially driving up future government disaster relief spending.

   2. Government intervention in insurance markets can have unintended consequences such as limiting the availability of insurance offered by private firms.

   3. Private insurers manage catastrophe losses by being selective about which risks to insure, by designing insurance contracts to provide incentives for risk-reducing behavior, and by charging prices that are high enough to enable them to diversify risk over time or transfer risk to third parties. By adopting private sector risk management and pricing practices, government insurance programs could reduce the burden they impose on taxpayers and minimize negative effects on private insurance markets.

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