Gamblers Led To How Insurance Works

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During their latest episode of the VALUE: After Hours Podcast, Cochrane, Taylor, and Carlisle discuss Gamblers Led To How Insurance Works. Here’s an excerpt from the episode:

Tobias: JT, you want to hit us with your vegetables?

Jake: Yes, sir. So, this week we’re going to talk about the early history of the insurance industry and actually how gambling sowed a lot of the seeds of the insurance industry, legit casinos in US. Some of this material is from Peter Bernstein’s book, Against the Gods, which is one of the all-time classics. It’s a great read, if you haven’t checked it out yet.

Tobias: There you go. It was on my book shelf too.

Jake: Right on cue.

Tobias: To hand. Yeah.

Jake: Well played, sir. So, we’ll start out with emperor Claudius, a Roman ruler around the time of Jesus Christ. He was eager to boost the corn trade within Rome. He made himself basically a one-man premium-free insurance company by taking responsibility for storm losses that are incurred by Roman merchants. So, he’s effectively insuring these Roman merchants. Actually, not that dissimilar to how the US government insures Bill’s house in Florida for us all without taking premiums. I’m just teasing, Bill.

So, let’s fast forward a few generations later. There’s this Roman jurist named– I think it’s Ulpian. I’m not exactly sure how it’s pronounced, but he created these tables that were life expectancies. These were actually the last word, basically, in actuarial tables for like 1,400 years. We made no progress. Not much happened.

And so, let’s fast forward now to the late 1600s. This guy named Blaise Pascal, he was a Frenchman and who unfortunately only lived 39 years before he passed away. He was always in really poor health, but he was a child prodigy in both math and science. As a teenager, he actually pioneered this mechanical calculator that worked– One of the first ones ever. He wrote several important papers on the scientific method. He invented the hydraulic press, and he also figured out how to use mercury to measure air pressure and actually had someone take it up into a higher elevation and he could measure the elevation. But he was also a philosopher. And of course, you might be familiar with Pascal’s wager, which might be his most longstanding thing.

Well, what you might not know about Pascal, at the time was approached by this rich, curious gambler named Chevalier de Méré, I believe. He was trying to figure out, how do you divide up a gambling game that’s called points, where one of the players has a slight lead–Let’s say you were going to stop the game and then figure out, how would we chop the pot, basically, and knowing that they’re coming at it from different scores. Pascal then reached out to Pierre de Fermat to consult on this problem–

A little background on Fermat. Along with Descartes, he was basically one of the leading mathematicians of the 17th century. Essentially, he created the modern theory of numbers, invented analytical geometry, contributed to early calculus. Newton actually gave him credit for it. And then, he worked also on light reflection and optics. So, another polymath. If you recall, we did an episode on the show, I don’t know, a year and a half ago or so, about this fiendishly difficult math proof that was called Fermat’s Last Theorem, that finally in 1994, this math guy named Andrew Wiles had solved it, but it had taken hundreds of years for people to try to figure it out.

Tobias: There’s a great book about it. Fermat’s Last Theorem is the name of the book.

Jake: That’s right.

Tobias: Fermat just gives this throwaway line where he says– [crosstalk]

Jake: It’s in the margin of something he’s writing. Yeah.

Tobias: Then, we’ve solved it using incredibly complex theories to get there.

Jake: Insane. Yeah. So, there’s this correspondence between Pascal and Fermat in 1654, and that became the foundation of probability theory. They were really the first to provide the mathematical proof behind what today we would call expected value calculations. So, basically, probability times risk, which is now the modern cornerstone of insurance and risk management. It seems obvious to us now, but before that, people had basically attributed the future to just fate. Whatever happened, no one could know. It was all up to the Gods. These guys finally brought some math enough through the enlightenment to make progress on this.

So, how could you insure against anything if you were just betting against the Gods, especially for the right price? In 1690, there’s a scientist and astronomer named Edmund Halley. He studied the data of births and deaths in this little town called Breslau. It’s now a city in Poland. The town fathers of this city had kept really meticulous records of annual births and deaths going back for centuries. And so, you had this really rich dataset. And Halley, his name might sound familiar because he pieced together that there was a series of comets, they were actually one comet that was appearing 1531, 1607, 1682. He predicted that the comet would reappear in 1758. It electrified the world at that time when it arrived right on schedule when he said it would. Unfortunately, he had died in 1742. So, that glory was entirely posthumous, but– [crosstalk]

Tobias: Did he use an inversion to predict the arrival of that comet? Did he look at the 10:3 inversion?

Jake: Yeah, it was a 10:3 inversion.

Matthew: [laughs]

Jake: So, now we know that as Halley’s comet, and it appears every 76 years. Last time was in 1986, and the next time will be 2061. So, hopefully, we’re all there to see Halley’s comet. Put that on your wish list.

Tobias: I saw it when I was a kid. I was four. I went and looked at the sky. It is a little white skid mark in the sky. I’ll never forget that.

Jake: Yeah.

Matthew: I was a little older than Toby, but I remember it being a thing where people go out and look. I don’t know if I actually saw it or not.

Tobias: Mom got me up at before the crack of dawn to look at this thing, pointed it out.

Jake: Yeah, it’s great.

Tobias: Sorry, dude.

Jake: Surprised you could see it from the bottom of the world.

Tobias: [laughs] I guess you are right. Turned in the right direction at the time.

Jake: Halley wasn’t just a stargazer. He used math to develop the first actuarial tables that were based on that Breslau data. This was in 1693. What it really allowed, the pricing of life insurance and annuities to be calculated. This math was actually very long overdue. If you remember, I was saying, it was back in AD 225, when Ulpian had made these tables in Rome, and now we have a replacement for it so much later.

But also, around that time, the English government had started taking and selling– They were taking a fiscal policy of selling annuities. What was crazy was that they ignored age completely and they were just like, it was the same price for everybody. This policy actually continued until 1789. So, literally almost a hundred years after Halley had already figured out the actuarial table, did the English government finally bake that into how they did this. And so, it’s good to know that governments have always been on the cutting edge throughout history.

Matthew: [laughs]

Jake: All right. So, last little piece of this is in 1687, there’s this guy named Edward Lloyd. He opened a coffee shop near the Thames. It was a favorite hangout of men from the ships who had come in that were moored at the London docks nearby. And so, 1696, he published this thing called Lloyd’s List regularly. It was filled with info about arrivals and departures of ships, intelligence of the conditions abroad and at sea. It was this continually rolling almanac about ocean-related things, maritime related.

News also came in from all over the world into this little coffee shop to help him create it. People are just coming and going. Ship auctions started taking place regularly in the corner. And then naturally, of course, gambling on what ships were going to return or not started to happen in another corner. As you’d expect, human nature being what it is. We like to gamble on things. By the way, talk about early network effects. You just have people showing up to the same place, they’re bringing information all over the place, you have auctions going, you have information, you have gambling. It was like a super app at the time.

So, of course, the individual risk takers would gather in this one corner, and they would look at deals to personally insure. And so, they would confirm their agreement to cover the losses if something went wrong and they figure out how much to get paid as a premium. It started from gambling and then evolved into– They would then write their name on the piece of paper under the terms of the contract. That’s where the term “underwriter” came from, is just literally writing your name under the words in a contract.

And so, this core group of underwriters then banded together, and they committed all their worldly possessions and all of their financial capital to secure their promises that they were making to make good on any losses that happened that they had insured. They had actually real skin in the game, which is interesting to think about when we’re talking about some bankers today that don’t seem to have as much skin in the game. But this syndicate of these original guys then were the early roots of what became Lloyds of London. It’s like this giant insurance syndicate now.

In multiple places, we have Fermat and Pascal trying to figure out this gambling like, “How do we chop the pot,” and that then led to the math of expected value. Then, we have people gambling on ships and whether they’re going to return or not that then eventually evolved into basically maritime insurance, and the rest of the insurance industry has sprung from there, basically. So, gambling leading to how insurance works.

Tobias: Similar thought process, probabilistic. Makes sense.

Jake: Probabilistic? That’s right. Risks, trying to take smart risk.

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