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Firms and individuals can be sub­ject to risks which, in the aggregate, form a class of homogene­ous cases. For example, out of a thousand firms, no one knows if a given firm will suffer a fire next year or not; but it is fairly well known that ten of them will. In that case, it may be of advantage for each of the firms to "take out insurance". They can pool their risks of loss, or a specialized firm, an "insurance company", can organize the pooling for them. Each firm will pay a certain premium, which will go into a pool to compensate those firms which suf­fer the fires.

And that is the principle of insurance.[1]

Basic Concepts

Insurance and Probability

Case probability

Case probability means, that we know some of the factors which determine the outcome of a particular event; but there are other determining factors which we don't know. The cases are individual, unique, and nonrepeatable, their result is uncertain. If in roulette a ball falls ten times on red in succession, the probability, that in the next turn will be the result black, is not greater than it was before. Football games cannot be predicted on the results of last games, nor can be presidential elections.[2]

Instances of case probability are uninsurable.[1]

Class probability

Class probability means, that we know nothing about an individual outcome, but we know everything about a whole class of events, and are certain about the future. In a lottery, for example, we know how many tickets are in total and how many will be drawn. But that does not say at all, if a particular ticket or tickets will win, and buying more tickets does not increase the chance of winning. An instance of class probability is called risk. It is possible to insure against risk, because the behavior of a class of events (or a reasonable subset of it) is well known.[3]

The field for the application of class probability is the field of the natural sciences, ruled by causality.[4]

Risk and Insurance

Risk occurs when an event is a member of a class of a large number of homogeneous events and there is fairly certain knowledge of the fre­quency of occurrence of this class of events. For example, a firm producing bolts knows from long experience that, say, 1 percent of these bolts will be defective. It will not know whether any given bolt will be de­fective, but it will know the proportion of the total number. This knowledge can be converted into a definite cost of the firm’s operations, especially where enough cases occur within a firm. In other situations, a given loss or hazard may be large and infrequent in relation to a firm’s oper­ations (such as the risk of fire), but over a large number of firms it could be considered as a "measurable" or actuarial risk. The firms can pool their risks, or a specialized firm - an insurance company - could organize the pooling for them.

Profit and loss are the results of entrepreneurial uncertainty. Actuarial risk is converted into a cost of business operation and is not responsible for profits or losses except in so far as the actuarial estimates are wrong.[1]

Main article: Probability

Homogeneity of classes

As soon as something spe­cific is known about individual cases, firms break down the cases into subaggregates to maintain homogeneity of classes, i.e., the similarity, as far as is known, of all individual members in the class with respect to the attribute in question. Thus, cer­tain subgroups within one age group may have a higher mor­tality rate because of their occupation; these will be segregated, and different premiums applied to the two cases. If there were knowledge about differences between subgroups, and insurance firms charged the same premium rate to all, then this would mean that the healthy or “less risky” groups would be subsidizing the riskier. Unless they specifically desire to grant such subsidies, this result will never be maintained in the competitive free market. In the free market each homogeneous group will tend to pay premium rates in proportion to its actuarial risk, plus a sum for interest income and for necessary costs for the insurance firms.[1]

Is Insurance Gambling?

People sometimes say, "When you buy fire insurance, you're betting that your house will burn down and the insurance company is betting it won't." But this misconstrues the nature of insurance.

In the first place, the insurance company clearly isn't gambling at all. If it only had a few clients, then it would be'. However, if the investors take on a significant part of the community as clients, then they are no longer gambling, assuming that their actuaries have correctly estimated the odds of a house burning down. The insurance company isn't betting that a given client's house will or won't burn down. It knows that some will and some won't, and it is only assuming that it has correctly identified the risk pool and placed equivalent homes into it. This is no more gambling than running a casino is; the owners of a Vegas resort aren't betting that each player who sits down at the blackjack table will bust.

Insurance is the opposite of gambling. When someone gambles, he typically gives up a small amount of money in exchange for a more uncertain future, in which he faces a large probability of getting nothing back but a small probability of winning a much larger sum than he initially paid out.

In contrast, with insurance the client pays a small amount of money (the premium) in exchange for a more certain future, in which his wealth will not fluctuate as wildly in different possible scenarios. There is a very legitimate sense in which someone who foregoes various types of insurance is living recklessly or "gambling."[5]


All providers of insurance have to cope with two major problems:

  • Moral hazard describes the changes in an insured individual's conduct - since he does not bear the full costs of his actions, it results in higher-risk exposure than occurs without insurance.
  • Adverse selection refers to the greater tendency of high-risk individuals to subscribe to insurance, which raises the price of insurance and can lead to the breakdown of the insurance market.[6]


In pre-modern agricultural societies, nearly everyone was at substantial risk from premature death due to malnutrition or disease, to say nothing of war. Most primitive societies at least attempt to hoard food and other provisions to tide them over hard times. And our tribal species intuitively grasped from the earliest times that it makes sense to pool resources, since there is genuine safety in numbers. Appropriately, given our ancestors’ chronic vulnerability, the earliest forms of insurance were probably burial societies, which set aside resources to guarantee a tribe member a decent interment. (Such societies remain the only form of financial institution in some of the poorest parts of East Africa.)

‘Bottomry’ - the insurance of merchant ships’ ‘bottoms’ (hulls) - was where insurance originated as a branch of commerce. Some say that the first insurance contracts date from early fourteenth-century Italy, when payments for securitas begin to appear in business documents. But the earliest of these arrangements had the character of conditional loans to merchants, which could be cancelled in case of a mishap, rather than policies in the modern sense. It was not until the 1350s that true insurance contracts began to appear, with premiums ranging between 15 and 20 per cent of the sum insured, falling below 10 per cent by the fifteenth century. A typical contract in the archives of the merchant Francesco Datini (c. 1335-1410) stipulates that the insurers agree to assume the risks ‘of God, of the sea, of men of war, of fire, of jettison, of detainment by princes, by cities, or by any other person, of reprisals, of arrest, of whatever loss, peril, misfortune, impediment or sinister that might occur, with the exception of packing and customs’ until the insured goods are safely unloaded at their destination. Gradually such contracts became standardized - a standard that would endure for centuries after it became incorporated into the lex mercatoria (mercantile law). These insurers were, however, not specialists, but merchants who also engaged in trade on their own account.

Beginning in the late seventeenth century, something more like a dedicated insurance market began to form in London. Minds were doubtless focused by the Great Fire of 1666, which destroyed more than 13,000 houses. Fourteen years later Nicholas Barbon established the first fire insurance company. At around the same time, a specialized marine insurance market began to coalesce in Edward Lloyd’s coffee house in London’s Tower Street (later in Lombard Street). Between the 1730s and the 1760s, the practice of exchanging information at Lloyd’s became more routinized until in 1774 a Society of Lloyd’s was formed at the Royal Exchange, initially bringing together seventynine life members, each of whom paid a £15 subscription. Compared with the earlier monopoly trading companies, Lloyd’s was an unsophisticated entity, essentially an unincorporated association of market participants. The liability of the underwriters (who literally wrote their names under insurance contracts, and were hence also known as Lloyd’s Names) was unlimited. And the financial arrangements were what would now be called pay as you go - that is, the aim was to collect sufficient premiums in any given year to cover that year’s payments out and leave a margin of profit. Limited liability came to the insurance business with the founding of the Sun Insurance Office (1710), a fire insurance specialist and, ten years later (at the height of the South Sea Bubble), the Royal Exchange Assurance Corporation and the London Assurance Corporation, which focused on life and maritime insurance. However, all three firms still operated on a pay-as-you-go basis. Figures from London Assurance show premium income usually, but not always, exceeding payments out, with periods of war against France causing huge spikes in both. (This was not least because before 1793 it was quite normal for London insurers to sell cover to French merchants. In peacetime the practice resumed, so that on the eve of the First World War most of Germany’s merchant marine was insured by Lloyd’s.)

Life insurance, too, existed in medieval times. The Florentine merchant Bernardo Cambi’s account books contain references to insurance on the life of the pope (Nicholas V), of the doge of Venice (Francesco Foscari) and of the king of Aragon (Alfonso V). It seems, however, that these were little more than wagers, comparable with the bets Cambi made on horse races. In truth, all these forms of insurance - including even the most sophisticated shipping insurance - were a form of gambling. There did not yet exist an adequate theoretical basis for evaluating the risks that were being covered.

Two Church of Scotland ministers (Robert Wallace and Alexander Webster) deserve the credit for inventing the first true insurance fund in 1744, to take care of the widows and children of deceased ministers of the Church of Scotland. Rather than having ministers pay an annual premium, which could be used to take care of widows and orphans as and when ministers died, they argued that the premiums should be used to create a fund that could then be profitably invested. Widows and orphans would be paid out of the returns on the investment, not just the premiums themselves. All that was required for the scheme to work was an accurate projection of how many beneficiaries there would be in the future, and how much money could be generated to support them.

The ‘Fund for a Provision for the Widows and Children of the Ministers of the Church of Scotland’ was the first insurance fund to operate on the maximum principle, with capital being accumulated until interest and contributions would suffice to pay the maximum amount of annuities and expenses likely to arise. If the projections were wrong, the fund would either overshoot or, more problematically, undershoot the amount required. After at least five attempts to estimate the rate of growth of the fund, Wallace and Webster agreed figures that projected a rise from £18,620 at the inception in 1748 to £58,348 in 1765. They were out by just one pound. The actual free capital of the fund in 1765 was £58,347. Both Wallace and Webster lived to see their calculations vindicated.

Within the next twenty years similar funds sprang up on the same model all over the English-speaking world, including the Presbyterian Ministers’ Fund of Philadelphia (1761) and the English Equitable Company (1762), as well as the United Incorporations of St Mary’s Chapel (1768), which provided for the widows of Scottish artisans. By 1815 the principle of insurance was so widespread that it was adopted even for those men who lost their lives fighting against Napoleon. A soldier’s odds of being killed at Waterloo were roughly 1 in 4. But if he was insured, he had the consolation of knowing, even as he expired on the field of battle, that his wife and children would not be thrown out onto the streets. By the middle of the nineteenth century, being insured was as much a badge of respectability as going to Church on a Sunday. Even novelists, not generally renowned for their financial prudence, could join. Sir Walter Scott took out a policy in 1826 to reassure his creditors that they would still get their money back in the event of his death.

By constantly increasing the number of people paying premiums, insurance companies and their close relatives the pension funds would rise to become some of the biggest investors in the world - the so-called institutional investors who today dominate global financial markets.[7]

Friendly societies

Main article: Friendly society

Various forms of friendly societies have existed since ancient China, Greece, and Rome. In Britain, they arose out of the guild system. Daniel Defoe wrote in 1697 that friendly societies were "very extensive" in England. In the mid-18th century, as the Industrial Revolution hastened the growth of British towns, the friendly society system became well established. Sometimes they were called fraternal societies, mutual aid societies, or benefit clubs. Similar organizations developed in the United States in the 19th century. Friendlies usually were formed by people with a common denominator, like the same occupation or same ethnic, geographic, or religious background.

Their lengthy success reflects that they were much more than benefit institutions. Friendlies were voluntary serf-help associations, organized by the members themselves. Friendlies served social, educational, and economic functions, bringing the idea of insurance and savings to those who might not have planned for the future. The social aspect of the friendlies should not be underestimated. Their meetings included lectures, dramatic performances, and dances both to inform and to entertain members.

Nineteenth-century commercial insurance companies couldn’t compete with the friendlies, so they focused on business clients and the rich. Workers were suspicious of the companies because of their numerous failures and scandals. Besides, insurance rates were higher than those the friendlies charged for comparable benefits.

Originally, friendlies insured against "disability to work," with little distinction between accident or sickness. This also came to mean "infirmity," i.e., insurance against old age. Most friendlies paid for a doctor’s services, burial expenses, life insurance, annuities to widows, and educational expenses for orphans. They built old-age homes and sanitariums for members and their families. Even in their early stages, they offered unemployment benefits for those in "distressed circumstances" or "on travel in search of employment." The most common pay-outs were for maternity leave and retirement pensions.[8]

A local country society had usually few members, reaching tens or at most hundreds of individuals (in some cases also covering the families of those insured). Until the 1820s, most friendly societies were local. Due to their vulnerability to adverse conditions and actuarial risks, they organized into "affiliated orders". (The "Independent Order of Odd Fellows" had 781 lodges with 47,638 members around 1835; at the end of 1886 there were 4,351 lodges, with 617,587 members.) The local lodges kept control of their sick insurance to prevent moral hazard. As the problem does not arise with burial insurance, there was a central funeral fund. Besides the actuarial importance of a greater pool of members, other advantages included more skilled management, more transparent rules, and the possibility of transferring benefits to a different part of the country - or even to the colonies if the worker moved. It was mainly the affiliated orders that spread, the idea of fraternalism to the United States. At its apex in the 1920s, roughly every third adult American male belonged to a fraternal society.

All societies formally refused applicants who were younger or older than a certain age, had serious or chronic health problems, or were employed in extremely risky occupations. But the requirements were relaxed in practice and even the poorer members of society could get insurance within the fraternal movement. High-risk workers, like miners and railway workers, mostly formed their own societies, paying higher premiums due to a higher risk of disability. (Part of the insurance was paid by the employer. Most English miners have been members to a friendly society, a similar system worked in Prussia, which served as a model for Bismarck’s system of compulsory insurance.)[6]

The friendlies did not collapse financially. Nor did they disappear because they failed to do their job for working people. They declined because of government action.

In Britain, the aristocrats feared the friendlies because they viewed their huge contributor funds as a means for political subversion. Eventually, a steadily growing web of uniform state-mandated benefits first duplicated, then absorbed the friendlies. The National Insurance Act of 1911 made insurance mandatory for some professions. State benefits were expanded, financed by compulsory contributions from employer and employee. Via subsidies, the friendlies were led to administer the state plan. Claims for benefits had to be filed with both systems. After WWII were the friendlies bypassed, and the loss of funding and higher state benefit rates drove many of them out of existence.

In the US, the friendlies pressed for their own legislation, forcing all new friendlies to adopt the same mortality rates. This would put them at a competitive disadvantage to the established societies. Instead of driving off the upstarts, this legislation blurred the distinction between friendlies and commercial life insurance companies. Legally they were grouped together. As a result, the commercial insurance companies gradually absorbed the friendlies.[8]

In both countries was the movement towards mandatory insurance supported by the medical profession. Where the friendly societies tried to secure good-quality health care for their members at reasonable prices, the doctors "felt strongly that conditions they had accepted in the marketplace should not be imposed on them by the state" and eventually "freed themselves from lay control."[6]

From insurance to welfare

Main article: Welfare state

No matter how many private funds were set up, there were always going to be people beyond the reach of insurance, who were either too poor or too feckless to save for that rainy day. Their lot was a painfully hard one: dependence on private charity or the austere regime of the workhouse. By the later nineteenth century, however, a feeling began to grow that life’s losers deserved better. The seeds began to be planted of a new approach to the problem of risk - one that would ultimately grow into the welfare state. These state systems of insurance were designed to exploit the ultimate economy of scale, by covering literally every citizen from birth to death.

The first system of compulsory state health insurance and old age pensions was introduced in Germany. The aim of Otto von Bismarck’s social insurance legislation, as he himself put it in 1880, was ‘to engender in the great mass of the unpropertied the conservative state of mind that springs from the feeling of entitlement to a pension.’ In Bismarck’s view, ‘A man who has a pension for his old age is . . . much easier to deal with than a man without that prospect.’ To the surprise of his liberal opponents, Bismarck openly acknowledged that this was ‘a state-socialist idea! The generality must undertake to assist the unpropertied.’ But his motives were far from altruistic. ‘Whoever embraces this idea’, he observed, ‘will come to power.’ Britain followed the Bismarckian example in 1908, when the Liberal Chancellor of the Exchequer David Lloyd George introduced a modest and means-tested state pension for those over 70. A National Health Insurance Act followed in 1911. Though a man of the Left, Lloyd George shared Bismarck’s insight that such measures were vote-winners in a system of rapidly widening electoral franchises. The rich were outnumbered by the poor. When Lloyd George raised direct taxes to pay for the state pension, he relished the label that stuck to his 1909 budget: ‘The People’s Budget.’

The First World War expanded the scope of government activity in nearly every field. With German submarines sending no less than 7,759,000 gross tons of merchant shipping to the bottom of the ocean, there was clearly no way that war risk could be covered by the private marine insurers. The standard Lloyd’s policy had in fact already been modified (in 1898) to exclude ‘the consequences of hostilities or warlike operations’ (the so-called f.c.s. clause: ‘free of capture and seizure’). But even those policies that had been altered to remove that exclusion were cancelled when war broke out. The state stepped in, virtually nationalizing merchant shipping in the case of the United States, and (predictably) enabling insurance companies to claim that any damage to ships between 1914 and 1918 was a consequence of the war.

With the coming of peace, politicians in Britain also hastened to cushion the effects of demobilization on the labour market by introducing an Unemployment Insurance Scheme in 1920. This process repeated itself during and after the Second World War. The British version of social insurance was radically expanded under the terms of the 1942 Report of the Inter-Departmental Committee on Social Insurance and Allied Services, chaired by the economist William Beveridge, which recommended a broad assault on ‘Want, Disease, Ignorance, Squalor and Idleness’ through a variety of state schemes. In a March 1943 broadcast, Churchill summarized these as: ‘national compulsory insurance for all classes for all purposes from the cradle to the grave’; the abolition of unemployment by government policies which would ‘exercise a balancing influence upon development which can be turned on or off as circumstances require’; ‘a broadening field for State ownership and enterprise’; more publicly provided housing; reforms to public education and greatly expanded health and welfare services.[7]

Insurance in the USA

The US property- and casualty-insurance regulation system claims to perform two main functions. First, to ensure insurers hold enough capital to remain solvent. All developed countries regulate solvency of their insurance companies in one way or another. The second function is to make insurance "affordable," that means price control. There are differences between states, but in most of the country, insurers need to have their rates authorized if they want to write insurance using them. The simplest way to improve insurer's solvency is to keep the premiums high, and to improve 'affordability' the premiums have to be low. Regulators claim they know how to strike the perfect balance.

The "affordability" function of the regulation resulted from the Sherman Antitrust Act. Historically, it was common practice for insurers to share their claims data for the purpose of insurance-rate making. Having access to good claims data meant that insurance companies could price and manage their business better, and expand and enter new market segments. The Sherman Act became effective for insurance in 1944, when the Supreme Court decided that insurance was interstate commerce and therefore should be regulated by Congress. As a result, the useful practice of data sharing, was outlawed by federal antitrust regulation.

But before the era of cheap computers, insurance could not exist without the data-sharing arrangements. So the McCarran-Ferguson Act was introduced in 1945, allowing the industry to return to the old practices but instructing the states to "protect" customers. And so, government involvement in rate making was mandated, without eliminating the allegedly undesirable claims-data sharing.

As is usually the case with other forms of price control, insurance-pricing regulation creates shortages. For example, since 1977 the Massachusetts Division of Insurance has been setting individual auto insurance rates for the entire state. Every insurer operating in the Commonwealth has had to use the government rates or leave the state. Since then, the number of insurers has fallen from more than 100 to just 19. In 2008 was the situation so dire that the current commissioner actually decided to liberalize the regime slightly to prevent more citizens from driving uninsured.[9]

Insurance in the UK

Until recently, British property and casualty pricing was totally unregulated. Regulators concentrated on the solvency function. The long tradition of freedom of enterprise resulted in the emergence of the unique London market of insurance. For centuries, London was the only place on Earth where it was possible to place big and nonstandard risks. Even today, if one wants to insure a power plant or a system of telecommunication satellites, London is the place to get it done.

The lack of pricing regulation in the United Kingdom resulted in a large number of pricing innovations being developed and tested there. A good example is the so-called GLM statistical approach, a mathematical methodology developed by two British actuarial software companies in the late '90s. Stripped-down versions of this innovation have since been exported to the United States and implemented with a few years' lag. Eventually, even the regulators started using GLM for granting rate approvals.

The same process is happening with actuarial-reserving and capital-modeling techniques and software. Since excessive regulation in the United States cripples innovative actuarial thought, most of the inventions are being developed in the United Kingdom and simply shipped across the Atlantic.

The less-regulated market gives Britons access to better insurance services. For example, a very sophisticated broker market has developed in the United Kingdom, providing policyholders with specialized products and advice. Complex nationwide software platforms created by the broker community allow huge price-comparison websites to provide millions of policyholders with binding quotes from nearly a hundred insurers in a few minutes.

Another example is the ease with which new insurance products can be created. In the US, the state regulators get very involved in the classification rules, underwriting guides, and even wording of the insurance contract. As a result, most private motor policies written in the last 30 years in the US have been written on one of the few standard ISO forms or some modifications of those. In the United Kingdom, where consenting parties are freer to enter an insurance contract of their choice, independent insurance brokers provide dozens of different policy wordings tailored to specific market segments. That means more choice for the customer.[9]


  1. 1.0 1.1 1.2 1.3 Murray N. Rothbard. "9. Risk, Uncertainty, and Insurance", Man, Economy and State online version, referenced 2009-12-04.
  2. Ludwig von Mises. "4. Case Probability", Human Action, online version, referenced 2009-10-10.
  3. Ludwig von Mises. "3. Class Probability", Human Action, online version, referenced 2009-10-10.
  4. Ludwig von Mises. "2. The Meaning of Probability", Human Action, online version, referenced 2009-12-04.
  5. Robert P. Murphy. "The Social Function of Insurance", Mises Daily, April 11, 2011. Referenced 2011-04-11.
  6. 6.0 6.1 6.2 Pavel Chalupnicek and Lukas Dvorak. "Health Insurance before the Welfare State - The Destruction of Self-Help by State Intervention" (pdf), The Independent Review, volume 13, n. 3, Winter 2009. Referenced 2010-01-08.
  7. 7.0 7.1 Niall Ferguson. The Ascent of Money, Chapter 4, p. 185-205. Published 2008, ISBN 9780141035482. Referenced 2012-06-23.
  8. 8.0 8.1 John Chodes. "Friendly Societies: Voluntary Social Security And More", The Freeman, March 1990, Volume: 40, Issue: 3. Referenced 2010-01-07.
  9. 9.0 9.1 Jan Iwanik. "The Regulated Insurance Market", Mises Daily, posted on November 17 2009, referenced 2010-01-07.

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