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The Actuary The magazine of the Institute & Faculty of Actuaries
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Insurance: A brief history

The first historical reference to insurance dates from 1760BC in the Babylonian Code of Hammurabi. The codification of personal and commercial law includes references to loans that a trader could secure on his ship. For an additional cost, it was possible to arrange a loan so that if the ship sank the loan was not repayable. This was effectively a form of marine insurance — with insurance not as a separate industry to banking, but as an optional add-on to lending. This state of affairs existed for 3000 years. The eventual impetus for the separation of insurance from banking and lending came from the church.

The strong growth in commerce and lending as Europe emerged from the Dark Ages led to the church re-emphasising its view that usury, lending at interest, was immoral and heretical. In a series of clarifications Pope Gregory IX proclaimed situations when the taking of interest was allowable, including when risk, in particular cargo insurance risk, was involved in the loan. “He who loans a sum of money to one sailing or going to market, since he has assumed upon himself a risk, is not to be considered a usurer who will receive something beyond his lot,” he said.

This appears to have led to the separation of insurance as a distinct, religiously acceptable activity and to a wave of innovation. Just over 100 years later, we have the first evidence of a reinsurance transaction. One merchant insuring goods being transported from Genoa to Sluys effectively bought facultative war cover, the war in question being the Hundred Years War, for the hazardous part of the voyage after Cadiz. Insurance at this stage was still a private transaction between individual merchants, and reinsurance a form of arbitrage.

Bubble trouble
The next great innovation in the financial industry was the development of joint stock companies, pioneered by the Dutch in the 17th century. Shortly after the invention of stock companies, concepts such as derivatives and short selling followed, with short selling being banned almost as soon as it was invented. The other ‘modern’ concept that quickly emerged was the speculative asset bubble, most famously Tulip Mania in Holland and 1720’s South Sea Bubble in the UK. The latter in particular had a profound impact on the development of insurance.

The South Sea Bubble had a number of interesting features including: the preferential issue of shares at prices effectively guaranteeing the recipients profits if they immediately sold them on; government intervention to keep the bubble inflated; and a large role played by speculative short selling in the eventual deflation of the bubble.

One key piece of government intervention was the 1720 Royal Exchange and London Assurance Act, later known by the pejorative title of the Bubble Act. The aim of the Act was to boost the South Sea share price by restricting the formation of other stock companies and so narrowing the range of possible competing investment opportunities. However, due to a £600 000 bribe, the Act went further in the area of marine insurance and effectively granted a duopoly of permitted marine insurance companies — Royal Exchange and London Assurance.

The only other permissible form of marine insurance was insurance by an individual writing on their own account with unlimited liability. This was the form of business conducted by Lloyd’s, which became the centre for growth in this area with business continuing in the traditional form and with risk sharing either by syndication or by facultative arbitrage.

The birth of reinsurance
Meanwhile, in the US and mainland Europe, insurance became dominated by stock companies with risk sharing by reciprocity between insurers. The rise in concentration risk with growing urban populations and industrial facilities threatened this model, culminating in the Hamburg Fire of 1842, which resulted in the bankruptcy of a number of German insurers. It showed the limitations of reciprocity and the need for independent, professional reinsurers without the requirement for insurers to reveal sensitive information to competitors. Cologne Re was formed as a result. The Great Fire of Glarus 15 years later led analogously to the formation of Swiss Re and, between them, the birth of treaty reinsurance.

The next formative event in the insurance industry was the San Francisco earthquake of 1906. It was one of the most significant natural disasters in American history, with insured losses totalling $250m. In 1906, as it is today, shake damage was excluded from most insurance policies. However, Cuthbert Heath’s famous instructions to pay all Lloyd’s policyholders irrespective of their policy conditions cemented Lloyd’s reputation and gave a huge boost to various innovations he was developing. These included earthquake and hurricane cover, per risk and catastrophic excess of loss. This laid the foundations for the modern insurance and reinsurance industries, including insurance cover for natural catastrophes and reinsurance cover via excess of loss treaties.

Interestingly, 1906-7 is perhaps the first and only clear example of a major natural catastrophe affecting the stock markets. The so-called Panic of 1907 led to a 50% peak-to-trough fall in the stock market and a series of bank runs. It was due to a lack of bank lending, including intra-bank lending, which was in turn due to a liquidity squeeze in New York and London. It resulted in a reworking of the architecture of the global financial markets, including a much greater federal role in the US. This may sound similar to more recent events, however, the liquidity squeeze was not due to problems with the housing market, but partly to the outflow of cash from New York and London to pay for rebuilding San Francisco.

Coping with catastrophes
The next major date in the evolution of risk sharing was Hurricane Andrew in 1992. Although a major event for the insurance industry with insured losses of around $15bn, a few forward thinkers quickly realised that things could have been much worse. Due to the huge growth in property values in catastrophe-exposed areas, they realised that, had Andrew struck directly on Miami as it had in 1926, or even if the 1906 earthquake was repeated, the resulting claims of $50bn to $100bn would be enormous and threaten the entire capital base of the insurance and reinsurance industries; then only $200bn. This led to a new innovation — catastrophe bonds, in which reinsurance was reinvented in the form of loans — with bonds issued by insurers for which the capital and interest would not be repaid following a predefined catastrophe.

Dramatic events in the insurance and finance industries in the past few years have firmly established catastrophe bonds as a source of protection for insurers and as an asset class for investors. Hurricane Katrina in 2005 gave a practical example of the potential lack of capacity in the reinsurance industry and gave a supply-side impetus to the need for insurers to issue catastrophe bonds. Meanwhile, the events on Wall Street and Main Street over the past 12 months have given a demand-side boost to catastrophe bonds. In a period where almost all asset classes (for example, equities, bonds, hedge funds, credit default obligations and property) have been shown to have a high correlation to credit risk, catastrophe risk has emerged as a potential source of zero-beta diversification when structured appropriately.

Graham Fulcher is a principal actuary in Watson Wyatt’s nonlife insurance team