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Are insurers ready for the big one? The big enchilada. The year when catastrophe losses surpass a breathtaking $100 billion loss. Surprisingly, I think the answer is yes. Let me explain.

The "cat" in "catastrophe"
When we bet on sports, we bet on a certain event happening (the Spurs winning, etc). In a risky world, people don't want certain events to happen -- such as getting in an automobile accident or having their house burn down -- so they buy insurance. Property and casualty (P&C) insurers are the ones on the other side of that bet. They set the rates (premiums) and in return pay policyholders money (claims) if bad things happen.

Who's afraid of the big, bad wolf?
Whereas certain P&C risks, such as automobile accidents or worker's compensation, are relatively predictable, catastrophes like Katrina and 9/11 are unpredictable, infrequent, and result in huge losses.

When hurricanes wreak havoc, cat insurers and re-insurers are usually the ones paying. Check out five-year stock charts of Montpelier Re (NYSE:MRH), RenaissanceRe (NYSE:RNR), Quanta (NASDAQ:QNTA) or PXRE (NYSE:PXT) and you'll see what I mean.

In 2001, U.S. insured catastrophe losses amounted to $26.5 billion, according to the Insurance Information Institute, the largest loss amount (unadjusted for inflation) in more than 20 years. In 2004, cat losses came in at $27.5 billion, setting a new record for "worst year ever" in P&C history.

But 2005 made other years look like child's play, with a $61.9 billion loss thanks to hurricanes Katrina, Rita, and Wilma hitting populated areas. The following year (2006) turned out to be a mild $9.2 billion cat loss year, which led to huge profits and soaring stock prices.

One hundred billion dollars
It seems inevitable that the industry will suffer a $100 billion loss. According to risk modeling firm AIR Worldwide, Florida, New York, and Texas had $4.6 trillion worth of total insured coastal exposure in 2004. They estimated that if a massive hurricane hit the East Coast, insured losses could amount to $110 billion.  

Are insurers ready?
It seems that in this post-Katrina world, insurers are ready for the big one. According to one high-level insurance executive, the problem in 2005 wasn't that rates were too low (prices were hard because of 9/11) -- it was that insurers' risk models didn't properly calculate their concentrations of exposure and risks. It's safe to say that those models have been updated to better account for coastal property values and loss exposures.

I also spent about an entire day reading as many P&C insurer first-quarter earnings call transcripts as possible, and came away thinking that insurers are maintaining discipline and holding the line on premium rates.

Bailing out
RealEstateJournal.com reported that Allstate (NYSE:ALL) is dropping homeowner policies in Long Island and New York City, and Metlife's (NYSE:MET) auto and home division is restricting new policies in the Northeast -- even with premiums increasing 20%-30% and including hurricane deductibles. Additionally, South Carolina residents are complaining of skyrocketing premiums, Texas homeowners are losing their windstorm coverage, and Nationwide has stopped selling homeowners insurance policies in Florida, despite getting a 54% rate increase approved.

In a somewhat stunning revelation of how much insurers are worrying about downside risk, RealEstateJournal reported, insurers were factoring the hurricane of 1938 into their thinking.

Risk is a four-letter word
Insurance rater AM Best forecast that if a really big loss event in the $90 billion to $100 billion range happened, 3%-7% of insurers would be vulnerable to insolvency. This hardly seems like a doomsday prediction for your average P&C insurer.

The thing about risk is that, for the most part, it can neither be created nor destroyed. Although it's true that total risk would be lessened if we all wore helmets and put up wind-resistant windows, the total risk in any given year is more or less constant, so if private insurers like Allstate aren't the fools rushing in, who's holding the bag?

With private insurers withdrawing from the coastal areas, either rates have to rise to attract those insurers back into the market, or someone has to step in. Because of political pressures, state insurance funds have filled the void.

"The private market has withdrawn from that area, and the people really have no other choice," said Jim Oliver, CEO of the Texas Windstorm Insurance Association. According to the Insurance Information Institute, state insurance funds are now taking very considerable risks. Florida's state-backed Citizens Property Insurance Corp.'s exposure to loss nearly doubled from $210 billion in 2005 to $408 billion in 2006. The U.S. FAIR (Fair Access to Insurance Requirement) Plan's exposure to loss grew to $387 billion in 2005 from $140 billion in 2001.

At the end of the day, it seems clear that state taxpayers who don't live in coastal areas and, to a lesser extent, the rest of the country, are subsidizing coastal policyholders. P&C insurers aren't exactly known for leaving money on the table, so it's safe to say the fact that they're exiting those areas indicates rates are truly inadequate. Thus, the state insurance funds writing those policies, many of which are currently in the hole, could find themselves blindsided by a major loss event, and will turn to taxpayers to foot the bill.

So given the thesis that taxpayers are holding the bag, that naturally leads us to the question: What should investors do if the big one does hit? More on that later.

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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.