Current Issue

Give Credit to the Gamblers and Speculators

Young noblemen in 17th and 18th century England generally enjoyed a good education, but they enjoyed the pleasures of life even more, especially gambling. Many of their fathers were rightly concerned, and a fair number of these sons were confronted with severe cuts to their allowances. But then one of them had an idea for how he could continue to enjoy gambling with his friends in spite of his limited means. The men formed associations in which the first one whose father died would pay off all their gambling debts from his inheritance. This made their creditors feel that they were likely to be paid.

But such speculation was not limited to the nobility. Back then "guarantees" (they were almost bets) were written for just about everything: the date when famous people would wed, when a siege might be lifted, on the likelihood of dying from excessive gin consumption. Above all, the custom of taking out several insurance policies for cargo ships, or one policy for an excessive amount, in the hope that they would sink was widespread. In 1774, the English government passed the Gambling Act, putting an end to this practice and initiating a long series of regulatory oversight measures.

Early Forms of Risk Protection

But insurance did not spring up overnight; it arose from a wide variety of institutions and customs. Its development was anything but linear, and its influences were diverse. The triumph of the Enlightenment and therefore of the sciences played as much a role as dramatic natural catastrophes. The expansion of global trade was an influencing factor as much as frivolous games of chance.

When the young noblemen started their games, there was already a long history of risk mitigation based on solidarity and sharing in fortunes. For millennia, it was common practice to distribute cargo among different ships, and the Genoans – once a leading trade power – established guilds in the Middle Ages to jointly insure ship transports. Other well-known and popular forms of early insurance include burial clubs, fire insurance and "friendly societies" or fraternal organizations, in England. They were often formed by a homogeneous group such as mineworkers, who would pay a small weekly contribution.

These models were based on a religious principle of solidarity, but faced many difficulties as a business model. Often, a large number of the insured died at the same time, such as in a mining accident, so the funds that had been collected were insufficient for the settlements of all surviving dependents. In addition, the premiums that were collected were invested poorly or not at all, and also had to cover operating costs. And finally, the illness-related death rate among the lower social classes was particularly high. This was not yet a viable insurance system.

The Power of Probability

Can nothing be done about fate? Is life unpredictable? For the Church, this was beyond all doubt. All people must die someday, and it is God who chooses the time. It was a sin to speculate on death or calculate when it would come. But this is exactly what happened in the aftermath of the Enlightenment. Scientists had been systematically researching the logic of the universe since the Renaissance, and a growing number of fields were permeated by rational thought, replacing the old ways of explaining things.

Mathematics played an important role, but once again it was the gamblers who provided the momentum for calculating probability – and this became the foundation of actuarial science in life insurance. In 1654, the Frenchman Chevalier de Méré wanted to find out what the probability was of rolling a six in a certain sequence. Mathematicians Blaise Pascal and Pierre de Fermat were able to use a number triangle to show the probability with an increasing number of dice.

This attempt at predicting the future and thereby challenging divine providence was in direct opposition to Church doctrine. Yet even the clergy were unable to completely ignore the logic of this model and other newly discovered laws. They coopted them for their own purposes and attempted to use statistical and scientific logic to prove the existence of divine order. Ironically, the death tables they began to collect later became a key tool for life insurance providers.

Shortly after Pascal and de Fermat, mathematicians in Great Britain, Germany and Holland applied probability calculations to life insurance – but the insurers were not yet convinced of such methods. Life insurance continued to be based on speculation, and the invention of stock shares did its part there. In England, the stock boom in the late 17th and early 18th centuries saw many insurance companies being founded, dubious ones in particular, leading to risky speculation by businesses and investors.

Life Becomes Predictable

Life insurance was put on a healthy foundation later on. The change came when mathematician James Dodson tried to purchase a life insurance policy from the Amicable Life Assurance Society. He was refused due to his advanced age of 45, which angered him so much that he proposed a mathematical solution for more equitable life insurance. Premium payments were to be calculated as a percentage of life expectancy. This was a fundamental principle for the Equitable Life Assurance Society, founded in 1762, five years after Dobson's death.

English philosopher and preacher Richard Price later managed to develop a cost model on this basis. In 1774, he wrote a treatise for Equitable Assurance on calculating profitability in life insurance. It had been discovered that bookkeeping did not provide reliable conclusions on the current financial situation of a company. It was impossible to estimate how much the individual life insurance policies were worth, much less determine whether Equitable Assurance was profitable or not using the current premium structure. Price lived up to his name and calculated a new premium model based on current and expected mortality. From then on, life insurance no longer had to engage in speculation.

Dwindling Omnipotence

The market economy ideals emerging largely from Great Britain put pressure on the strict religious thinking in Southern Europe. Nevertheless, skepticism toward science remained high. This started to change when a natural disaster cast doubt on the traditional interpretation of divine omnipotence. In 1755, an undersea earthquake off the coast of Portugal triggered a tsunami that destroyed almost the entire city of Lisbon. It was especially vexing that the red light district in particular was spared from destruction – but not the churches.

Many believed that if an omnipotent God wanted such a thing, then He could not be benevolent; and if He were benevolent, then He could not be omnipotent. The theological problem of omnipotence raised its head again and paved the way for the ideals of the Enlightenment in the South – and thus the expansion of the ideas of insurance beyond Northern Europe. Additionally, the earthquake provided the impetus for seismology, which plays an important role for insurers.

Rising From the Rubble and Ashes

Another catastrophe marked a turning point in the history of property insurance. In 1666, the center of London was destroyed by a massive fire. Almost nothing was insured at that time. For innovative business people, the reconstruction of the city was a financial boon. Nicholas Barbon, an economist, banker and early provider of mortgages, earned a fortune in the rebuilding and then founded the first truly modern insurance company in 1681, the Insurance Office for Houses.

Barbon was an early proponent of free market theory and for him, it was the prospect of income from premiums rather than the solidarity that was enticing. It was also clear to him that the new business should be a joint stock company, the first in the industry. Although the company did not enjoy long-term success, using stock shares to raise debt capital for insurance would become an important advantage over the traditional mutual insurance associations. This ensured sufficient operating capital and allowed risk capital to be managed separately. Subsequently, a great number of insurance companies were founded. Some of these even had their own firehouses that, in case of fire, would attempt to save houses insured by that company first.

A Moral Obligation

However, a great number of insurance companies were founded with purely speculative motives, and many of those failed by 1720 at the latest, when the South Sea Bubble burst and countless investors were driven to ruin. By contrast, the coffee house Edward Lloyd opened in 1688 fared rather well. Ship owners met there with colleagues, who over time came to underwrite each other's transport risks, and Lloyd's became a market that brought brokers and customers together.

In 1776, Scottish economist Adam Smith, one of the most prominent promoters of this new economic thinking in Great Britain, published his book "The Wealth of Nations" in which he not only proposed free competition as a prerequisite for prosperity, but also discussed the personal responsibility of individuals. He praised insurance as a rational institution and elevated it to a moral obligation. He considered not insuring oneself as showing "thoughtless rashness and presumptuous contempt of the risk."

Beyond the Borders

The onset of the Industrial Revolution and the expansion of colonies brought many new risks that had to be insured. English society's immense demand for sugar from the colonies was associated with problems previously unknown in the 18th century. Refining sugar products was extremely capital-intensive, and not just because of the many slaves needed. Aside from the dangers posed by sea transport, there was the risk of fire in the refining vats and rum distilling equipment.

In 1782, an association of 84 sugar refinery owners founded Phoenix Assurance in London, the first truly significant global, modern insurance company that saw long-term success. Their success was also due to capitalization via stock shares and the availability of debt capital that enabled rapid geographic expansion. One year after being founded, the company was already insuring refineries in St. Petersburg, Smyrna (now Izmir, Turkey), Lisbon and beyond within a short amount of time. It was also the first company to establish branch offices abroad, which substantially improved risk distribution.

Modern insurance began to gradually break down the traditional forms of mitigating risk such as burial clubs and fire insurance. The scientific basis of actuaries, the modern business form of a joint stock company and the geographic distribution of risk made the British insurance model an unbeatable business idea. It would conquer the world over the next few centuries.