24 March 2017

In a modern capitalist economy, almost everything is for sale, including risks. Markets can transfer known risks to people or institutions who can handle the risk more effectively. The cost of rebuilding my house if it is destroyed by fire is beyond my means. For an insurance company with many properties on its books and many shareholders, by contrast, the loss is easily manageable. Trade in risk may be motivated by such insurance—the prudent management of risk—but it may also be about wagering: that is, individuals backing their own, distinctive, perception of the nature and likelihood of an event. People trade risk because they see the same risk differently. I think Arsenal will win the match, but you favour Chelsea. So we take bets on the outcome, and one of us will win and the other will lose. We have divergent opinions, or information, or we believe we do. In the long run, of course, it is only the bookmaker, or the house, that wins. Financial markets accommodate both prudent insurers and reckless gamblers. They provide investors with an opportunity to diversify their portfolios, and allow gamblers to bet on future movements in interest rates. The coexistence of the two can allow speculators to make profits by stabilising prices—buying when markets are fearful, and selling when they are greedy. But when the gambling motive overwhelms the insurance motive, speculation becomes destabilising and then risk, far from being minimised by careful management, becomes concentrated in the hands of those who understand least what they are doing. And when regulators perceive insurance when they should see wagering, their actions magnify a crisis rather than minimise it. Such destabilising speculation, mischaracterised by regulatory authorities as prudent risk assessment, is what caused the global financial crisis of 2008. The coexistence of insurance and gambling goes back to the earliest days of markets in risk, and the interaction of the two has been central to financial history. But it was four developments in the second half of the 17th century that combined to frame the way we think about risk, and the institutions we have for dealing with it, through to the present day. Coffee is thought to originate in Arabia, and was introduced to Europe in the 16th century. Coffee houses were found in Venice before 1650, but the Grand Café on Oxford High Street, which opened in 1654 (and is still a coffee shop today) was the first in England. The fashion spread: English gentlemen gathered in coffee shops to talk and do business—and to wager. The era saw a resurgence of gambling. Humans have played games of chance since the beginning of history—primitive dice, made from animal bones, have been found at prehistoric sites. But public policy towards gambling has regularly swung from prohibition to liberalisation and back, as regulatory regimes do. The restoration of the monarchy in 1660 ended Puritan restrictions on gambling and much else, and the pendulum swung decisively towards permissiveness. It has done so again in the last 50 years. Another development was in the understanding of probability. Historians trace the beginnings of such analysis to a correspondence between two great French mathematicians, Blaise Pascal and Pierre de Fermat, in the winter of 1654. The correspondence was supposedly prompted by a conversation between Pascal and the Chevalier de Méré, an aristocrat with some flair for the card table. It may seem strange that the discovery of probability came so late in the history of thought. After all, the ancient Greeks were no mean mathematicians, and they gambled: and the mathematics of probability is not, as mathematics goes, especially difficult. But before the 17th century there was little concept of probability in the modern sense. Fortune represented the will of the gods, and could not be described by the kinds of laws appropriate for the natural world. The word “probable” shares the same root as “approve,” and “probable” would mean “accepted by the best authorities.” Even in the 18th century, Edward Gibbon would write of Hannibal’s crossing of the Alps, “the account of Livy is the more probable,” by which he meant widely acknowledged and approved, “but that of Polybius is the more true.” The development of probabilistic thinking depended on the Enlightenment’s rejection of argument from authority and the diminished influence of religious doctrine. And modern insurance also traces its roots to the second half of the 17th century. Contracts with some of the character of insurance policies have a long history, but the Great Fire of London in 1666 led directly to the establishment of the first insurance business, the Insurance Office, in the following year. The Hand in Hand Insurance Company, founded in 1696, is thought to be the oldest surviving insurer: it is today part of Aviva. These offices didn’t just pay up when there was a claim, as a modern insurer does: they sent an engine to try to put the fire out. On some London buildings you can still see fire marks, the means by which insurers, or their operatives, could recognise the property of their policyholders. Such competition was not a very efficient system: the different private fire services established agreements for mutual assistance, but it was not until the 19th century that London enjoyed a public fire service, funded from taxation. The coffee shops of London, named for their proprietors, provided a venue for these new businesses. Tom’s coffee shop was an early centre of insurance. Jonathan’s was a venue for securities trading, and is regarded as the genesis of the London Stock Exchange. White’s and Brooks’s, the first London clubs for gentlemen, were founded as gaming houses. The most famous coffee shop of all was that of Edward Lloyd. Gentlemen met there to wager on the weather, the tide and the fate of ships at sea. Merchants realised that they could use this facility to lay off part of the risk of overseas trade. In due course that coffee shop became the insurance market we know today as Lloyd’s