Insurance and Catastrophes

Catastrophes provide a principal justification for insurance. Traditional conceptions of catastrophes miss three critical elements. (1) Many catastrophes—the liability revolution in the United States, for example—are not bolts from the blue. Rather, they develop over many years and result from human activity. (2) Conventional, experiencedbased models for assessing losses often smudge the distinction, so critical for catastrophes, between probability and magnitude of loss. (3) Normal insurance contracts, with heavy copayments for small losses but little charge at the margin for large ones, perform poorly when the insured can tradeoff probability and size of loss—a phenomenon we label distribution distortion. The structures of optimal insurance contracts are assessed.

Keywords: catastrophe, insurance, moral hazard, copayment, experience rating, distribution distortion