A seemingly endless parade of British lizards, winsome cavemen, and good neighbors populates our TV screens. They tell us how much money we could save by switching insurance companies. Here’s a real money-saving proposition: We, as a nation, could save many billions of dollars by switching from government to insurance. You heard that right. Insurance, properly designed, can help us to manage the sort of hazards from which we traditionally have looked to government to protect us.
Few phrases in the English language can put people to sleep as quickly as “a brief history of insurance,” but please bear an overview of how the institution developed — until the growth of government stopped its evolution. It’s a more interesting tale than you’d think, involving the sons of revolutionaries, the Great Fire of London, and, yes, pirates.
Insurance owes its beginnings to one of mankind’s earliest forays into high-risk, high-return innovation: maritime shipping. As the technological revolution of navigation allowed first the Portuguese and then others to engage in expeditions overseas, traders looked for ways to manage their risks. A successful ship bringing back spices from Asia could make its investors rich, while a ship lost to a storm or pirates could ruin them. This risk led to the first insurance against disaster: the “non-recourse loan.” Investors would pool their resources and underwrite a number of trading expeditions. This spread the risks, which made it possible for the profitable voyages to offset the losses. When a ship returned, the investment pool shared in the profits; when a ship was lost, the loan financing the expedition was forgiven, and everybody took a relatively small loss.
In the late 17th century, such investors often gathered at a London coffeehouse owned by one Edward Lloyd, who provided his customers with reliable shipping information. The investors continued to meet there after Lloyd’s death in 1713 and later formed the Society of Lloyd’s, which became Lloyd’s of London, the first modern insurance institution. The non-recourse loan evolved into the premiums Lloyd’s members collected from shipping firms. Competition between Lloyd’s members (“names”) ensured a reasonable rate. Competition also drove Lloyd’s to become increasingly expert in various types of ships, the competency of the captains and crews, and the relative risks associated with, say, a voyage into the Baltic vs. a voyage to the East Indies.
The premiums charged rose with the perceived risk. This helped to curb overinvestment in high-risk voyages and encouraged shippers to use risk-management techniques such as assigning the more competent crews and ships to the higher-risk destinations, sailing in convoys to provide more security, and arming ships and crews. Shipping risks fell over time — in part because nation-states invested in navies to thwart pirates — driving down premiums even further.
As the highly successful Atlanta investor Frank Hanna notes, this process deserves much credit for allowing America to grow rapidly as the flow of ships from Old Europe to the New World greatly increased during the 17th and 18th centuries. Absent insurance, the massive waves of ship-borne migration across the Atlantic might have never occurred.
About the same time as Edward Lloyd’s customers were knocking back the java and concocting their deals, other minds were asking how insurance could protect against everyday risks. The leading mind among them rejoiced in the name of Nicholas If-Jesus-Christ-Had-Not-Died-For-Thee-Thou-Hadst-Been-Damned Barbon. (Yes, that was his real name.) Nicholas was the son of Praise-God Barebone, a Fifth Monarchist preacher nominated by Oliver Cromwell to the assembly that replaced the Rump Parliament in 1653 and became known as Barebone’s Parliament. An opponent of monarchy, Praise-God attempted to stop the Restoration earned himself a trip to the Tower of London. Nicholas wisely gave up politics for the building trade, which provided immense opportunity following the Great Fire in 1666.
Nicholas soon became the devastated city’s leading builder. He recognized that real estate was a valuable asset that could form a foundation of capital. This insight led him into two extremely successful ventures. He founded a land bank that lent people money in the form of mortgages against their property; and he invented fire insurance. The great fire had destroyed 13,000 houses. Barbon and some colleagues founded the Fire Office in 1680 to help reduce such suffering in the future, offering policies to provide coverage for 5,000 buildings.
#page#Barbon did more than promise to defray costs in the event of disaster. He formed a private fire brigade, staffed, as one observer put it, with “watermen and other lusty persons,” to help put out fires. The Fire Office also instituted “fire marks,” identifying insured buildings so that assistance could reach them more quickly in the event of a fire. Interestingly, the British government entered the market shortly afterwards but was unable to compete with Barbon, who persuaded potential customers that the government could not devote the attention necessary to the task.
Barbon was also a leading critic of mercantilism. He should be recognized as a great figure in economic history. The fact that so many people don’t know his name may be due to the myths that have grown up around the history of firefighting. Everyone who has seen Gangs of New York knows about private firefighters more interested in brawling with rival brigades than in stopping fires, standing by as uninsured buildings burn down. Yet this is a caricature; there is no economic sense in it. Fire in an uninsured building can easily spread to an insured one, and firefighters fighting with rivals while letting fires burn present no great advertisement for their services. Historians have suggested that this never even happened in America. There is no reason to think it happened in England, either, where London fire brigades acted cooperatively in the spirit of serving the public. G. V. Blackstone reports in A History of the British Fire Service:
Through keen competition the insurance companies had voluntarily shouldered the public duty of fire extinction. One company (ALBION) publicly stated in the early 19th century (1809) that as well as no longer putting up fire marks, its firemen were enjoined to render the utmost assistance to all who needed it. . . . The houses of the poor — who could not afford insurance anyway — were dealt with out of charity and for the good name it brought to the company.
What led the insurance companies to get out of the fire-suppression business was what is known as the free-rider problem. In London by the mid-19th century, two-thirds of buildings were uninsured. This trend was reinforced by the rapid expansion of cities during the Industrial Revolution. Private fire suppression remained adequate, but it placed an increasing strain on insurers’ business model. When municipalities began to take over firefighting from insurance companies, it was a relief to the companies’ stockholders and partners — but the level of protection offered did not improve.
This is how government provision of “insurance” came to be. Today, government risk-management schemes include the National Flood Insurance Program, the Pension Benefit Guaranty Corporation (PBGC), the Federal Deposit Insurance Corporation, Social Security, the Federal Crop Insurance Corporation, and myriad other, less-known federal and state programs. These were intended to create a more equitable system of risk management than what private interests might have developed.
But there is an important difference: While private insurers estimate the risk of various activities, price it accordingly, and thereby encourage insured parties to carefully consider whether undertaking the activity is worth the cost, government insurance does the opposite: It minimizes losses from engaging in risky activities by taxing less risky ones, encouraging hazardous practices.
A prime example of this is one of the most serious threats to our economy today, the deficits of the defined-benefit pension plans provided by large corporations, state and local governments, and labor unions. These schemes pay out today, seeking revenues to cover the costs tomorrow. This business model works well when the entities involved are expanding, as a growing payer base provides continued solvency. However, as large firms’ labor forces shrink thanks to productivity improvements, technological shifts, or demographics — and union membership rolls shrink in tandem — the burden of supporting a large population of retirees with diminished revenues from a smaller work force threatens the pension system’s solvency.
#page#This dilemma has been recognized for years. The Pension Benefit Guaranty Corporation was set up to regulate and ensure the solvency of such pension plans. In theory, this pension-insurance program is funded through premiums assessed on covered companies. But the agency’s premiums are set by Congress and therefore do not adequately reflect the risks involved. This underpricing of risk creates a perverse incentive to underfund pension plans, the obligations of which can be pushed onto the PBGC when they become unsustainable. Given this model, it is not surprising that the PBGC announced a deficit of $21 billion last September. We should now expect a taxpayer bailout and a hollow promise by the public insurer to do a better job in the future.
A similar dynamic characterizes the National Flood Insurance Program, which encourages building in high-risk areas, thus exposing taxpayers to huge liabilities in the event of disaster. In many cases, a government insurance program simply drives private insurers out of the market, as in Florida’s hurricane-insurance scheme, or causes massive increases in insurance rates, as with Michigan’s crazy rule requiring companies to offer only their costliest auto policies to consumers.
These situations arise when government officials listen to the complaints of special pleaders. Such complaints often lead to the creation of government-sponsored insurance pools — artificial groupings of high-risk parties who are offered policies at “fairer rates,” meaning rates set by politics rather than by the market. Inevitably, insurers pass along those costs to their other customers. In this way, safer drivers subsidize less-safe drivers; healthy individuals subsidize unhealthy ones; the young subsidize the old. As individuals respond by shifting to the government-subsidy scheme, the private industry may find it impossible to survive.
This problem is exacerbated by another aspect of insurance — “moral hazard.” Buying insurance weakens your attentiveness to risk. For example, if you know that your homeowners’ insurance policy will reimburse you for losses from burglary, you are less likely to take expensive steps to secure your home, such as buying a top-of-the-line alarm system. Having automotive collision insurance might make you more likely to drive in a snowstorm instead of staying home until the weather clears up.
Moral hazard is a problem for private insurance, but it is a big problem for government-run alternatives, too. Private insurers can address this problem in part by mandating that insured parties take certain precautions, by more intensive on-site investigations, by limiting coverage to specified parties, and by more frequent rate changes. But all too often, state regulators limit these options.
On balance, we’re probably better off in many situations relying on private insurance rather than political programs for risk mitigation. In many ways, America is already ahead of the game, using insurance to manage health risks and unemployment protection in innovative ways.
But we should think more creatively about how to use insurance and related products, replacing our government-run Social Security with other strategies to manage the risks of aging and disability. Private, risk-based pension insurance could help secure the retirements of millions of Americans. Going even further, insurance could help preserve endangered species. Today, landowners find the value of their property dropping if an endangered species is found on it, leading to a perverse incentive to prevent this risk by clear-cutting that habitat. Insurance could be designed to preserve the value of the land in the event that a protected species is discovered. Insurance offered early enough in a child’s life could help fund his higher education, providing a much-needed hedge against rising tuition. And when managing the risks surrounding emerging industries, such as cybersecurity, insurance could play a critical role in helping develop the basic institutions needed for those industries to thrive — much as Nicholas Barbon did in developing firefighting.
Insurance can play a crucial role in shrinking the size of government while protecting Americans against risk. In an America increasingly anxious about over-mighty government, expanding insurance into new areas should be a no-brainer — so easy, in fact, even a caveman could do it.
– Mr. Murray is vice president for strategy at the Competitive Enterprise Institute. He is grateful to CEI’s president, Fred Smith, for his contributions to the ideas behind this piece.