The modern life insurance contract has an ancient origin, and the story of how it came to be reveals a struggle between two forces: The Crypt and The Casino. The Crypt is a final burial place, sometimes under churches. The need for the Crypt is certain, as Benjamin Franklin wrote, “nothing is certain except death and taxes”. The Crypt is also expensive, and while death is certain, the time of your death is not. This duality is the source of the basic need from which the primordial form of life insurance arose: The Babylonian bottomry loan.
Nearly four thousand years ago in Babylon, in the 1750s BC, The Code of Hammurabi allowed for a form of loan to fund a merchant voyage, backed by the bottom of the ship. This loan would not have to be repaid if the ship sank or was captured by pirates. This loan was outright usurious, charging upwards of 40%. These “bottomry loans” were not normal debt, they were part insurance and part debt.
Around three thousand years ago, on the Greek island of Rhodes, The Lex Rhodia established a principle of general average, where the owners of the cargo on a ship would have to share the loss if any cargo was thrown out during a voyage. Imagine, you are a merchant sailor in the mediterranean in 1000 BC, there’s a squall, your ship is leaking, and in order to survive, you have to start throwing cargo off the boat to reduce the weight. There are three owners, Alexandros, Bacchus and Cyril. Most of the cargo happened to be Cyril’s, but by the principle of general average, Alexandros and Bacchus would have to absorb some of that loss. This is how the modern insurance concept of risk pooling was born, in the chaos of the ancient maritime trade routes.
The Apollonian logic of securing the Crypt was always in tension with that other force, the Dionysian ecstasy of the Casino, and that temptation to greed and fraud that corrupted the original intent of the bottomry loan. This was common enough that that Demosthenes referred to bottomry fraud in his speech Against Zenothemis, about how Protus loaned money to Zenothemis to ship a load of grain from Sicily to Athens, but Zeno had lied about the grain, the ship was empty, and conspired to sink the ship to cancel out the debt.
The Athenians had another proto-insurance like arrangement they called the eranoi, which were mutual aid clubs where they would pool funds and give each other interest-free loans. These played a part in the trial of Socrates in 399 BC, when his friends tried to bail him out using eranoi funds.
Rome produced the first instance I can find of life insurance proper, not just maritime cargo insurance. The Roman burial clubs, or collegia funeraticia, were one of the few private associations that Roman authorities allowed to exist. The Collegium of Diana and Antinous, founded at Lanuvium in 133 AD, would charge an up-front fee and a monthly fee (in money and wine) to fund burial expenses for the members.
Each new member had to pay an entrance fee of 100 sesterces, an amphora of good wine, and a monthly contribution of 5 asses. If the member were up to date with his monthly dues when he died, the association would pay his funeral expenses up to 300 sesterces. quote source
The wine was probably enjoyed at the funerals honoring the deceased members. The members were mostly urban poor and slaves, under the condition that the slave masters allowed them to join.
Medieval Europe saw forms of life insurance-like arrangements through the many guilds that made up the Hanseatic League, such as during the Black Death (1346-1353 AD), where some guilds would become surrogate families for widows and children who survived the plague.
Up until this time, the way insurance had been done was heavily intertwined with debt. The problem for those seeking insurance in Christendom in the fourteenth century was usury laws that banned the charging of interest. Pope Gregory IX condemned bottomry laws as usury in 1236.
Despite this, clever Genoese merchants crafted a legal loophole in 1347 that transferred risk from the merchant to the insurer in exchange for a premium. This didn’t violate usury law because it was not technically a loan. What started as a loophole to insure maritime trade gradually led to insuring human lives, where in Genoa, Enrico Bensa documented examples of masters insuring pregnant slaves, and husbands insuring pregnant wives. As the variety of applications of this new insurance contract continued to grow, the Casino took over, and people were using insurance to gamble on Papal Conclaves. This got bad enough that Genoa banned this practice in 1467.
The reason the Casino took over so quickly was that in the 15th century, actuarial science hadn’t been invented. Without a theory of probability, the correct prices of risk couldn’t be known, so it devolved into gambling. But the cosmic irony of how probability came to be is that it was the Casino that created it!
In the summer of 1654 in France, the Chevalier de Méré was confused about his gambling losses so he wrote to the great mathematician Blaise Pascal. Pascal wrote to Pierre de Fermat and the two of them accidentally invented the theory of probability as a side quest while trying to work out who owes who what in games of chance. The central idea they developed was expected value. To calculate the expected value, you multiply the cost of an outcome by the probability of that outcome. So for example, in a coin toss game with a $10 outcome, the expected loss is $5, since 0.50*$10 =$5.00.
The theory of probability really matured with the addition of Jacob Bernoulli’s Law of Large Numbers, published posthumously in 1713, which proved that the observed frequency of an event converges to its true probability as the number of trials increase.
The final ingredient that was missing came from the most unlikely of places: an astronomer. Edmond Halley (of Halley’s Comet fame) found a Polish priest who had been recording mortality data in Breslau. Halley used this data to create a survivor table, the first actuarial able, published in 1693. The man who made a name for himself by studying Halley’s Comet also laid the empirical foundations for life insurance. He showed that the comet in 1682 was the same as the one seen in 1607 and 1531 using Newton’s laws, and he showed the probability that different cohorts of people would die in a given year.
Halley died but his work was picked up again 20 years later in an act of spite. James Dodson, a mathematician and fellow of the Royal Society, applied to the Amicable Life Assurance Society, but was rejected because they didn’t admit anyone over the age of 45.
Dodson created his own Life Assurance society out of spite, and being a mathematician, he also used his skills to reveal how poorly the Amicable society had structured their life insurance, like how all the members paid a single fixed fee. Dodson picked up Halley’s work and developed the idea of a level premium so members could pay a single fee repeatedly throughout their life, but also there was no age exclusion. If you were older, your premiums were higher, but the level premium guaranteed a fixed price over time. He calculated using Halley’s life expectancy tables.
Securing the Crypt had been put on a sound mathematical foundation when Dodson founded the The Equitable Life Assurance Society in 1762. Over the next dozen years, the animal spirits of the Casino would possess the economy of London. People were taking out life insurance policies on random people, the King, members of death row, and even soldiers fighting in the Seven Years’ War.
It got so bad that Parliament had to pass the Life Assurance Act of 1774, which put an end to all this reckless gambling on other peoples’ lives. The Act introduced the concept of insurable interest, which required that the policy owner personally suffer some financial loss if the insured dies. So, children have an insurable interest in their parent’s lives, wives have an insurable interest in their husbands’ lives, etc. No one can claim to have an insurable interest in the lives of a random inmate who might be sentenced to death. Or the King, for that matter. When the King dies, there is a successor, his subjects cannot claim to suffer any financial loss.
For the next two centuries, life insurance had become a household institution, a boring piece of the financial infrastructure of everyday life. The Crypt was secure and correctly priced, but the seductive lights of the Casino beckoned. Deep within the American financial markets, a new product, the Mortgage-Backed Security, introduced in 1970, promised to give bond-like predictability together with real-estate equity-like growth.
Over time these Mortgage-Backed Securities inspired CDOs (Collateralized Debt Obligations). Then these CDOs would be bought and sold with leverage (multiplying gains and losses with debt). The pricing of these CDOs depended heavily on the ratings agency’s, like Moody’s. What happened in practice is closer to fraud and gambling. The incentives were such that real estate agents and banks could give mortgages to “subprime” borrowers who would probably default. The real estate agents would get their commission, then banks could sell the mortgages immediately to the investment banks, who would bundle them into CDOs, and have a rating agency give it an artificially high rating, boosting it’s price, then they could magnify their gains by taking out a leveraged position, using debt.
The life insurance giant AIG had large leveraged positions in these CDOs, and when the subprime mortgages started going into default, this debt-fraud-gambling popped in the great 2008 financial crisis. Lehman Brothers (no relation) went bankrupt that year, and the financial sector had to be bailed out by the federal government. AIG’s life insurance division was still safe and boring, but the pull of the Casino was too strong. That ancient temptress never dies.
Next time you look at your life insurance premiums, think about the last 4000 years, about the Babylonian merchants and their bottomry loans, about the Roman burial soceities paying in wine, about the Genoese merchants making loopholes through medieval usury law, and about the French mathematicians who settled a gambling dispute, and the English mathematician who rationalized the whole business of life insurance out of spite. This story is old and ongoing, and neither the Crypt nor the Casino have permanently vanquished the other.