This was a piece of work that was long overdue. The first record we have of the concept of annuities dates back to 225 AD, when an authoritative set of tables of life expectancies was developed by a leading Roman jurist named Ulpian. Ulpian's tables were the last word for over 1400 years!
Halley's work subsequently inspired important efforts in calculating life expectancies on the Continent, but his own government paid no attention to his life tables at the time. Taking their cue from the Dutch use of annuities as a financing device, the English government had attempted to raise a million pounds by selling annuities that would pay back the original purchase price to the buyer over a period of 14 years-but the contract was the same for everyone, regardless of their age! The result was an extremely costly piece of finance for the government. Yet the policy of selling annuities at the same price to everyone continued in England until 1789. The assumption that the average life expectancy at birth was about 14 years was at least an improvement over earlier assumptions: in 1540, the English government had sold annuities that repaid their purchase price in seven years without regard to the age of the buyer.'7
After the publication of Halley's life tables in Transactions in 1693, a century would pass before governments and insurance companies would take probability-based life expectancies into account. Like his comet, Halley's tables turned out to be more than a flash in the sky that appears once in a lifetime: his manipulation of simple numbers formed the basis on which the life-insurance industry built up the data base it uses today.
One afternoon in 1637, when Graunt was just seventeen years old and Halley had not yet been born, a Cretan scholar named Canopius sat down in his chambers at Balliol College, Oxford, and made himself a cup of strong coffee. Canopius's brew is believed to mark the first time coffee was drunk in England; it proved so popular when it was offered to the public that hundreds of coffee houses were soon in operation all over London.
What does Canopius's coffee have to do with Graunt or Halley or with the concept of risk? Simply that a coffee house was the birthplace of Lloyd's of London, which for more than two centuries was the most famous of all insurance companies.18 Insurance is a business that is totally dependent on the process of sampling, averages, independence of observations, and the notion of normal that motivated Graunt's research into London's population and Halley's into Breslaw's. The rapid development of the insurance business at about the time Graunt and Halley published their research is no coincidence. It was a sign of the times, when innovations in business and finance were flourishing.
The English word for stockbroker-stock jobber-first appeared around 1688, a hundred years before people started trading stocks around the Buttonwood tree on Wall Street, New York. Corporations of all kinds suddenly appeared on the scene, many with curious names like the Lute-String Company, the Tapestry Company, and the Diving Company. There was even a Royal Academies Company that promised to hire the greatest scholars of the age to teach the 2,000 winners of a huge lottery a subject of their own choosing.
The second half of the seventeenth century was also an era of burgeoning trade. The Dutch were the predominant commercial power of the time, and England was their main rival. Ships arrived daily from colonies and suppliers around the globe to unload a profusion of products that had once been scarce or unknown luxuries-sugar and spice, coffee and tea, raw cotton and fine porcelain. Wealth was no longer something that had to be inherited from preceding generations: now it could be earned, discovered, accumulated, invested-and protected from loss.
Moreover, toward the end of the century the English had to finance the sequence of costly wars with the French that had begun with Louis XIV's abortive invasion of England in May 1692 and ended with the English victory at Blenheim and the signing of the Treaty of Utrecht in 1713. On December 15, 1693, the House of Commons established the English national debt with the issue of the million pounds of annuities mentioned above. In 1849, Thomas Babington Macaulay, the great English historian, characterized that momentous event with these resounding words: "Such was the origin of that debt which has since become the greatest prodigy that ever perplexed the sagacity and confounded the pride of statesmen and philosophers."19
This was a time for London to take stock of itself and its role in the world. It was also a time to apply the techniques of financial sophistication demanded by war, a rapidly growing wealthy class, and rising overseas trade. Information from remote areas of the world was now of crucial importance to the domestic economy. With the volume of shipping constantly expanding, there was a lively demand for current information with which to estimate sailing times between destinations, weather patterns, and the risks lurking in unfamiliar seas.
In the absence of mass media, the coffee houses emerged as the primary source of news and rumor. In 1675, Charles II, suspicious as many rulers are of places where the public trades information, shut the coffee houses down, but the uproar was so great that he had to reverse himself sixteen days later. Samuel Pepys frequented a coffee house to get news of the arrival of ships he was interested in; he deemed the news he received there to be more reliable than what he learned at his job at the Admiralty.
The coffee house that Edward Lloyd opened in 1687 near the Thames on Tower Street was a favorite haunt of men from the ships that moored at London's docks. The house was "spacious ... wellbuilt and inhabited by able tradesmen," according to a contemporary publication. It grew so popular that in 1691 Lloyd moved it to much larger and more luxurious quarters on Lombard Street. Nat Ward, a publican whom Alexander Pope accused of trading vile rhymes for tobacco, reported that the tables in the new house were "very Neat and shined with Rubbing." A staff of five served tea and sherbet as well as coffee.
Lloyd had grown up under Oliver Cromwell and he had lived through plague, fire, the Dutch invasion up the Thames in 1667, and the Glorious Revolution of 1688. He was a lot more than a skilled coffee-house host. Recognizing the value of his customer base and responding to the insistent demand for information, he launched "Lloyd's List" in 1696 and filled it with information on the arrivals and departures of ships and intelligence on conditions abroad and at sea. That information was provided by a network of correspondents in major ports on the Continent and in England. Ship auctions took place regularly on the premises, and Lloyd obligingly furnished the paper and ink needed to record the transactions. One corner was reserved for ships' captains where they could compare notes on the hazards of all the new routes that were opening up-routes that led them farther east, farther south, and farther west than ever before. Lloyd's establishment was open almost around the clock and was always crowded.
Then as now, anyone who was seeking insurance would go to a broker, who would then hawk the risk to the individual risk-takers who gathered in the coffee houses or in the precincts of the Royal Exchange. When a deal was closed, the risk-taker would confirm his agreement to cover the loss in return for a specified premium by writing his name under the terms of the contract; soon these one-man insurance operators came to be known as "underwriters."
The gambling spirit of that prosperous era fostered rapid innovation in the London insurance industry. Underwriters were willing to write insurance policies against almost any kind of risk, including, according to one history, house-breaking, highway robbery, death by gin-drinking, the death of horses, and "assurance of female chastity"-of which all but the last are still insurable.20 On a more serious basis, the demand for fire insurance had expanded rapidly after the great fire of London in 1666.
Lloyd's coffee house served from the start as the headquarters for marine underwriters, in large part because of its excellent mercantile and shipping connections. "Lloyd's List" was eventually enlarged to provide daily news on stock prices, foreign markets, and high-water times at London Bridge, along with the usual notices of ship arrivals and departures and reports of accidents and sinkings.* This publication was so well known that its correspondents sent their messages to the post office addressed simply "Lloyd's." The gov
ernment even used "Lloyd's List" to publish the latest news of battles at sea.
In 1720, reputedly succumbing to a bribe of £300,000, King George I consented to the establishment of the Royal Exchange Assurance Corporation and the London Assurance Corporation, the first two insurance companies in England, setting them up "exclusive of all other corporations and societies." Although the granting of this monopoly did prevent the establishment of any other insurance company, "private and particular persons" were still allowed to operate as underwriters. In fact, the corporations were constantly in difficulty because of their inability to persuade experienced underwriters to join them.
In 1771, nearly a hundred years after Edward Lloyd opened his coffee house on Tower Street, seventy-nine of the underwriters who did business at Lloyd's subscribed 0100 each and joined together in the Society of Lloyd's, an unincorporated group of individual entrepreneurs operating under a self-regulated code of behavior. These were the original Members of Lloyd's; later, members came to be known as "Names." The Names committed all their worldly possessions and all their financial capital to secure their promise to make good on their customers' losses. That commitment was one of the principal reasons for the rapid growth of business underwritten at Lloyd's over the years. And thus did Canopius's cup of coffee lead to the establishment of the most famous insurance company in history.
By the 1770s an insurance industry had emerged in the American colonies as well, though most large policies were still being written in England. Benjamin Franklin had set up a fire-insurance company called First American in 1752; the first life insurance was written by the Presbyterian Ministers' Fund, established in 1759. Then, when the Revolution broke out, the Americans, deprived of Lloyd's services, had no choice but to form more insurance companies of their own. The first company to be owned by stockholders was the Insurance Company of North America in Philadelphia, which wrote policies on fire and marine insurance and issued the first life-insurance policies in America-six-term policies on sea captains.*21
Insurance achieved its full development as a commercial concept only in the eighteenth century, but the business of insurance dates back beyond the eighteenth century BC. The Code of Hammurabi, which appeared about 1800 BC, devoted 282 clauses to the subject of "bottomry." Bottomry was a loan or a mortgage taken out by the owner of a ship to finance the ship's voyage. No premium as we know it was paid. If the ship was lost, the loan did not have to be repaid.t This early version of marine insurance was still in use up to the Roman era, when underwriting began to make an appearance. The Emperor Claudius (10 BC-AD 54), eager to boost the corn trade, made himself a one-man, premium-free insurance company by taking personal responsibility for storm losses incurred by Roman merchants, not unlike the way governments today provide aid to areas hit by earthquakes, hurricanes, or floods.
Occupational guilds in both Greece and Rome maintained cooperatives whose members paid money into a pool that would take care of a family if the head of the household met with premature death. This practice persisted into the time of Edward Lloyd, when "friendly societies" still provided this simple form of life insurance.tt
The rise of trade during the Middle Ages accelerated the growth of finance and insurance. Major financial centers grew up in Amsterdam, Augsburg, Antwerp, Frankfurt, Lyons, and Venice; Bruges established a Chamber of Assurance in 1310. Not all of these cities were seaports; most trade still traveled over land. New instruments such as bills of exchange came into use to facilitate the transfer of money from cus tomer to shipper, from lender to borrower and from borrower to lender, and, in huge sums, from the Church's widespread domain to Rome.
Quite aside from financial forms of risk management, merchants learned early on to employ diversification to spread their risks. Antonio, Shakespeare's merchant of Venice, followed this practice:
(Act I, Scene 1)
The use of insurance was by no means limited to shipments of goods. Farmers, for example, are so completely dependent on nature that their fortunes are peculiarly vulnerable to unpredictable but devastating disasters such as drought, flood, or pestilence. As these events are essentially independent of one another and hardly under the influence of the farmer, they provide a perfect environment for insurance. In Italy, for example, farmers set up agricultural cooperatives to insure one another against bad weather; farmers in areas with a good growing season would agree to compensate those whose weather had been less favorable. The Monte del Paschi, which became one of the largest banks in Italy, was established in Siena in 1473 to serve as an intermediary for such arrangements.22 Similar arrangements exist today in lessdeveloped countries that are heavily dependent on agriculture.23
Although these are all cases in which one group agrees to indemnify another group against losses, the insurance process as a whole functions in precisely the same manner. Insurance companies use the premiums paid by people who have not sustained losses to pay off people who have. The same holds true of gambling casinos, which pay off the winners from the pot that is constantly being replenished by the losers. Because of the anonymity provided by the insurance company or the gambling casino that acts as intermediary, the actual exchange is less visible. And yet the most elaborate insurance and gambling schemes are merely variations on the Monte del Paschi theme.
The underwriters active in Italy during the fourteenth century did not always perform to the satisfaction of their customers, and the complaints are familiar. A Florentine merchant named Francesco di Marco Datini, who did business as far away as Barcelona and Southampton, wrote his wife a letter complaining about his underwriters. "For whom they insure," he wrote, "it is sweet to them to take the monies; but when disaster comes, it is otherwise, and each man draws his rump back and strives not to pay."24 Francesco knew what he was talking about, for he left four hundred marine insurance policies in his estate when he died.
Rembrandt's Storm on the Sea of Galilee. (Reproduction courtesy of the Isabella Stewart Gardner Museum, Boston.)
(Act I, Scene 1)
Activity in the insurance business gained momentum around 1600. The term "policy," which was already in general use by then, comes from the Italian "polizza," which meant a promise or an undertaking. In 1601, Francis Bacon introduced a bill in Parliament to regulate insurance policies, which were "tyme out of mynde an usage amonste merchants, both of this realm and of forraine nacyons."
The profit on an investment in goods that must be shipped over long distances before they reach their market depends on more than just the weather. It also depends on informed judgments about consumer needs, pricing levels, and fashions at the time of the cargo's arrival, to say nothing of the cost of financing the goods until they are delivered, sold, and paid for. As a result, forecasting-long denigrated as a waste of time at best and a sin at worst-became an absolute necessity in the course of the seventeenth century for adventuresome entrepreneurs who were willing to take the risk of shaping the future according to their own design.
Commonplace as it seems today, the development of business forecasting in the late seventeenth century was a major innovation. As long as mathematicians had excluded commercial applications from their theoretical innovations, advances toward a science of risk management had to wait until someone asked new questions, questions that, like Graunt's, required lifting one's nose beyond the confines of balla and dice. Even Halley's bold contribution to calculations of life expectancies was to him only a sociological study or a game with arithmetic played out for the amusement of his scientific colleagues; his failure to make any reference to Pascal's theoretical work on probability thirty years earlier is revealing.
An enormous conceptual hurdle had to be overcome before the shift could be made from identifying inexorably determined mathematical odds to estimating the probability of uncertain outcomes, to turn from collecting raw data to deciding what to do with them once they were in hand. The intellectual advances from this point forward are in many ways more astonishing than the advances we have witnessed so far.
Some of the innovators drew their inspiration by looking up at the stars, others by manipulating the concept of probability in ways that Pascal and Fermat had never dreamed of. But the next figure we meet was the most original of all: he directed his attention to the question of wealth. We draw on his answers almost every day of our lives.
n just a few years the commanding mathematical achievements of Cardano and Pascal had been elevated into domains that neither had dreamed of. First Graunt, Petty, and Halley had applied the concept of probability to the analysis of raw data. At about the same time, the author of the Port-Royal Logic had blended measurement and subjective beliefs when he wrote, "Fear of harm ought to be proportional not merely to the gravity of the harm, but also to the probability of the event."
In 1738, the Papers of the Imperial Academy of Sciences in St. Petersburg carried an essay with this central theme: "the value of an item must not be based on its price, but rather on the utility that it yields."' The paper had originally been presented to the Academy in 1731, with the title Specimen Theoriae Novae de Mensura Sortis (Exposition of a New Theory on the Measurement of Risk); its author was fond of italics, and all three of the italicized words in the above quotation are his.* So are all those in the quotations that follow.
It is pure conjecture on my part that the author of the 1738 article had read the Port-Royal Logic, but the intellectual linkage between the two is striking. Interest in Logic was widespread throughout western Europe during the eighteenth century.
Both authors build their arguments on the proposition that any decision relating to risk involves two distinct and yet inseparable elements: the objective facts and a subjective view about the desirability of what is to be gained, or lost, by the decision. Both objective measurement and subjective degrees of belief are essential; neither is sufficient by itself.
Against the Gods: The Remarkable Story of Risk Page 10