Lessons from history VIII – On the social utility of finance
How an 18th century British doctrine suggests a complete overhaul of financial regulation
....Life insurance was invented in the 15th century. From the very beginning, people have used life insurance as a way to bet on lives, which made catholic powers furious. In 1419, the Venetian Senate banned all bets on the Pope’s life. In most of Europe, there was a blanket prohibition on gambling, which also encompassed life insurance. There were only a few exceptions; for example, merchants were allowed to insure slaves, which fostered colonial trade. Nevertheless, in England, life insurance was never prohibited, partly because it was less developed, partly because of Anglicanism, and partly because of Common Law traditions.
So in the 18th century, England became home to all kind of bets. In 1771, speculation broke out on the true sex of a French soldier and diplomat, the Chevalier d’Eon. Rumors that he was a woman had been circulating since late 1770. Since the Chevalier refused to be examined, two lawsuits were brought by brokers, to determine whether a friend’s testimony constituted a proof. Courts dismissed the brokers’ claims. However, the immorality of bets became more and more blatant. Here is a telling story: “In 1750, a man collapsed at the door to the club and was carried in. The members of the club immediately made bets whether he was dead or not, and when the surgeon made ready to bleed him, the wagerers ‘for his death interposed’, objecting that ‘it would affect the fairness of the bet’” [Clark, 1999].
The insurable interest doctrine
Faced with such scandals, the British Parliament had to react, but without hampering insurance markets, which are an essential step toward an advanced capitalist economy. This resulted in the Gambling Act of 1774, which introduced the “insurable interest doctrine”: insurance contracts that do not aim at protecting a legitimate economic interest shall be annulled. This also helps to address the “moral hazard” problem where the insured person is more interested in seeing the insurance pay out than in preventing the harm it is designed to protect against.
But what is a legitimate interest? In 1777, Mr. Spenser, a rich British soldier, died on his way to the West Indies. A good husband, he had arranged for a £500 annuity to be paid to his wife, Mary Spenser. Cautiously, she also took a £5,000 insurance policy on her husband. The underwriters refused to pay: they claimed that Mary Spenser had no “economic interest in her husband’s life” since he had already provided for an annuity. However, the court held the contract to be valid, and underwriters had to pay the promised amount. Indeed, common law considers that a person has an unlimited interest in their own life, or in that of their spouse. The case was one of the first decisions to elaborate the “insurable interest” doctrine after the adoption of the Gambling Act, the major historical pillar of insurance regulation in England.
The Spenser case illustrates the difficulty of distinguishing economic activity from pure speculation. There is always a speculative element in finance, and it needs to be acknowledged. But one could argue that on insurance policy markets, the balance has been found, thanks to the “insurable interest” doctrine. Everybody now understands the difference between protecting your family through life insurance and betting on a stranger’s life. Historians have argued that the ensuing development of private insurance was a great step forward, which among other things paved the way for the Welfare State. Could better regulation of today’s commodity and credit derivatives markets bring similarly significant contributions to global development?....
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