WORLD INSURERS HAVE FACED tough times in the twenty-first century. The terrorist attacks of September 11, 2001, led to losses of about US$23 billion. A decade later, 2011 was one of the industry’s worst ever according to Swiss Reinsurance: economic losses from natural and industrial disasters were US$370 billion worldwide, while insured losses totalled US$116 billion.

According to the Insurance Information Institute, the industry’s worst year on record was 2005. That year saw flooding in India, a devastating earthquake in Pakistan, a train derailment in Japan, and three major hurricanes striking the United States. Hurricane Katrina was the single worst natural disaster ever to hit the United States: over 1400 dead, nearly US$50 billion in losses to private insurers, and US$23 billion in losses to the government’s National Flood Insurance Program. Moreover, these figures significantly understate the true level of loss because many people were uninsured or underinsured.

For Canadian insurers, 2013 was a record-breaking year. They paid out more than $3 billion for damages due to severe weather. In June massive flooding in Alberta caused an estimated $5 billion in economic damages, about $2 billion of which was insured. The Insurance Bureau of Canada called it the largest insured disaster in Canadian history. On July 6th a train derailment in Lac-Mégantic, Quebec, caused explosions that destroyed most of the downtown and killed 47 people. Insured damages are estimated at $50 million. Two days later, heavy rain in Toronto caused severe flash flooding and resulted in about $940 million in insured damages—Ontario’s largest insured natural disaster. Then in December, eastern Canada was hit hard by ice storms resulting in more than $200 million in insured damages.

Anyone who lives in an area threatened by natural disasters knows that uncertainty is a feature of the real world. Up to this point, we have assumed that people make decisions with knowledge of exactly how the future will unfold. (The exception being health insurance decisions, which we discussed in Chapter 19.) In reality, people often make economic decisions, such as whether to build a house in a coastal area, without full knowledge of future events. As the victims of recent catastrophes have learned, making decisions when the future is uncertain carries with it the risk of loss.

It is often possible for individuals to use markets to reduce their risk. For example, flood victims who had insurance were able to receive some, if not complete, compensation for their losses. In fact, through insurance and other devices, the modern economy offers many ways for individuals to reduce their exposure to risk.

However, a market economy cannot always solve the problems created by uncertainty. Markets do very well at coping with risk when two conditions hold: when risk can be reasonably well diversified and when the probability of loss is equally well known by everyone. Over the past several years, the significant increase in extreme weather events has led many insurers to sharply reduce coverage of weather-related loss: they no longer believe that profits from areas with good weather will offset losses from flood- and tornado-prone areas. But in practice, the second condition is often the more limiting one. Markets run into trouble when some people know things that others do not—a situation that involves what is called private information. We’ll see that private information can cause inefficiency by preventing mutually beneficial transactions from occurring—especially in insurance markets.

In this chapter we’ll examine why most people dislike risk. Then we’ll explore how a market economy allows people to reduce risk at a price. Finally, we’ll turn to the special problems created for markets by private information.