A decade ago—as a stunt for a radio program—I phoned one of the UK’s leading betting shops and tried to take a bet that I was going to die within a year. The woman on the end of the phone refused: it was against company policy. That was an unprofitable decision, since I am, after all, still alive. But a betting shop won’t gamble on life and death. A life insurance company, by contrast, does little else.
Legally and culturally, there’s a clear distinction between gambling and insurance. Economically, the difference is not so easy to see. Both the gambler and the insurer are agreeing that money will change hands depending on what transpires in some unknowable future.
It’s an old—almost primal—idea. Gambling tools such as dice date back millennia; perhaps five thousand years in Egypt. In India, twenty-five centuries ago, they were popular enough to be included in a list of games that the Buddha refused to play.1 Insurance may be equally ancient. The Code of Hammurabi—a law code from Babylon, in what is now Iraq—is nearly four thousand years old. It devotes considerable attention to the topic of “bottomry,” which was a kind of maritime insurance bundled together with a business loan: a merchant would borrow money to fund a ship’s voyage, but if the ship sank, the loan did not have to be repaid.2
Around the same time, Chinese merchants were spreading their risks by swapping goods among ships—if any one ship went down, it would contain a mix of goods from many different merchants.3 But all that physical shuffling around is a fuss. It’s more efficient to structure insurance as a financial contract instead. A couple of millennia later, that’s what the Romans did, with an active marine insurance market. Later still, Italian city-states such as Genoa and Venice continued the practice, developing increasingly sophisticated ways to insure the ships of the Mediterranean.
Then, in 1687, a coffeehouse opened on Tower Street, near the London docks. It was comfortable and spacious, and business boomed. Patrons enjoyed the fire; tea, coffee, and sherbet; and, of course, the gossip. There was a lot to gossip about: London had recently experienced the Great Plague, the Great Fire, the Dutch navy sailing up the Thames, and a revolution that had overthrown the king.
But above all, the regulars at this coffeehouse loved to gossip about ships: what was sailing from where, with what cargo—and whether it would arrive safely or not. And where there was gossip, there was an opportunity for a wager. The patrons loved to bet. They bet, for instance, on whether Admiral John Byng would be shot for his incompetence in a naval battle with the French (he was). The gentlemen of Lloyd’s would have had no qualms about taking my bet on my own life.
The proprietor saw that his customers were as thirsty for information to fuel their bets and gossip as they were for coffee, and so he began to assemble a network of informants and a newsletter full of information about foreign ports, tides, and the comings and goings of ships. His name was Edward Lloyd. His newsletter became known as Lloyd’s List. Lloyd’s coffeehouse hosted ship auctions, and gatherings of sea captains who would share stories. And if someone wished to insure a ship, that could be done, too: a contract would be drawn up, and the insurer would sign his name underneath—hence the term “underwriter.” It became hard to say quite where coffeehouse gambling ended and formal insurance began.
Naturally, underwriters congregated where they could be best informed, because they needed the finest possible grasp of the risks they were buying and selling. Eight decades after Lloyd had established his coffeehouse, a group of underwriters who hung out there formed the Society of Lloyd’s. Today, Lloyd’s of London is one of the most famous names in insurance.4
But not all modern insurers have their roots in gambling. Another form of insurance developed not in the ports, but in the mountains—and rather than casino capitalism, this was community capitalism. Alpine farmers organized mutual aid societies in the early sixteenth century, agreeing to look after one another if a cow—or perhaps a child—got sick. While the underwriters of Lloyd’s viewed risk as something to be analyzed and traded, the mutual assurance societies of the Alps viewed risk as something to be shared. A touchy-feely view of insurance, maybe, but when the farmers descended from the Alps to Zurich and Munich, they established some of the world’s great insurance companies.5
Risk-sharing mutual aid societies are now among the largest and best-funded organizations on the planet: we call them “governments.” Governments initially got into the insurance business as a way of making money, typically to fight some war or other in the turmoil of Europe in the 1600s and 1700s. Instead of selling ordinary bonds, which paid in regular installments until they expired, governments sold annuities, which paid in regular installments until the recipient expired. Such a product was easy enough for a government to supply, and they were much in demand.6 Annuities were popular products because they, too, are a form of insurance—they insure an individual against the risk of living so long that all her money runs out.
Providing insurance is no longer a mere money-spinner for governments. It is regarded as one of their core priorities to help citizens manage some of life’s biggest risks—unemployment, illness, disability, and aging. Much of the welfare state, as we’ve seen, is really just a form of insurance. In principle some of this insurance could be provided by the marketplace, but faced with such deep pools of risk, private insurers often merely paddle. And in poorer countries, governments aren’t much help against life-altering risks, such as crop failure or illness. Private insurers don’t take much of an interest, either. The stakes are too low, and the costs too high.
That is a shame. The evidence is growing that insurance doesn’t just provide peace of mind, but is a vital element of a healthy economy. A recent study in Lesotho showed that highly productive farmers were being held back from specializing and expanding by the risk of drought—a risk against which they couldn’t insure themselves. When researchers created an insurance company and started selling crop insurance, the farmers bought the product and expanded their businesses.7
But for private insurers, there isn’t much money to be made supplying crop insurance in tiny Lesotho. They can do better by playing on our fears of the slings and arrows of outrageous fortune and selling richer consumers overpriced cover against overblown risks, like a cracked mobile phone screen.
Today, the biggest insurance market of all blurs the line between insuring and gambling: the market in financial derivatives. Derivatives are financial contracts that let two parties bet on something else—perhaps exchange rate fluctuations, or whether a debt will be repaid or not. They can be a form of insurance. An exporter hedges against a rise in the exchange rate; a wheat-farming company covers itself by betting that the price of wheat will fall. For these companies, the ability to buy derivatives frees them up to specialize in a particular market. Otherwise, they’d have to diversify—like the Chinese merchants four millennia ago, who didn’t want all their goods in one ship. And the more an economy specializes, the more it tends to produce.
But unlike boring old regular insurance, for derivatives you don’t need to find people with a risk they need to protect themselves against: you just need to find someone willing to take a gamble on any uncertain event anywhere in the world. It’s a simple matter to double the stakes—or multiply them by a hundred. As the profits multiply, all that’s needed is the appetite to take risks. Before the international banking crisis broke in 2007, the total face value of outstanding derivatives contracts was many times larger than the world economy itself. The real economy became the sideshow; the side bets became the main event. That story did not end well.8