Catastrophe Insurance, Capital Markets, and Uninsurable Risks

This article addresses the question why private insurance companies in the United States are not willing to provide insurance against catastrophic events (such as earthquakes, hurricanes, and floods). One expects such a market to exist, since the demand for catastrophe insurance is high and the traditional reasons for risks to be uninsurable (such as moral hazard) are not present. We argue that catastrophic risks require insurers to hold large amounts of liquid capital, but institutional factors (accounting, tax, and takeover risk) make insurers reluctant to do this. In other words, the basic problem rests in the capital markets, not in the insurance markets. Instruments such as Act of God bonds and catastrophe futures and options contracts are being developed to solve the problem. Nevertheless, it appears that the government will continue to be an essential player in catastrophe insurance markets.