INSURANCE AND CATASTROPHES

Catastrophes provide a principal justification for insurance. Traditio nal conceptions of catastrophes miss three critical elements. (1) Marr y catastrophes-the liability revolution in the United States, for exam ple-are not bolts from the blue. Rather, they develop over many years and result from human activity. (2) Conventional, experienced-based mo dels for assessing losses often smudge the distinction, so critical fo r 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 distri bution distortion. Tire structures of optimal insurance contracts are assessed.