1. THE PROBLEM OF CATASTROPHE RISK The risk of large losses from
natural disasters in the U.S. has significantly increased in recent
years, straining private insurance markets and creating troublesome
problems for disaster-prone areas. The threat of mega-catastrophes
resulting from intense hurricanes or earthquakes striking major
population centers has dramatically altered the insurance environment.
Estimates of probable maximum losses (PMLs) to insurers from a mega-
catastrophe striking the U.S. range up to $100 billion depending on the
location and intensity of the event (Applied Insurance Research, 2001).1
A severe disaster could have a significant financial impact on the
industry (Cummins, Doherty, and Lo, 2002; Insurance Services Office,
1996a). Estimates of industry gross losses from the terrorist attack on
September 11, 2001 range from $30 billion to $50 billion, and the
attack's effect on insurance markets underscores the need to understand
the dynamics of the supply of and the demand for insurance against
extreme events, including natural disasters. Increased catastrophe risk
poses difficult challenges for insurers, reinsurers, property owners and
public officials (Kleindorfer and Kunreuther, 1999). The fundamental
dilemma concerns insurers' ability to handle low-probability,
high-consequence (LPHC) events, which generates a host of interrelated
issues with respect to how the risk of such events are 1 These probable
maximum loss (PML) estimates are based on a SOD-year "return" period.