Adverse Selection and Institutional Change in Eighteenth Century Marine Insurance

Adverse Selection and Institutional Change in Eighteenth Century Marine Insurance

Chris Kingston

Amherst College

May 2008

Overview

In 1720:• Underwriting by private individuals

By 1844:• In Britain: Lloyd’s of London (a marketplace for individual

underwriting)• In US, France, Holland: Joint-stock marine insurance

corporations

Agency Problems in Marine Insurance

For Underwriters:• Moral Hazard: potential for fraud • Adverse Selection: merchants had better information about risks

“Concealment of circumstances, in matters of insurance, especially in time of war, [is] constantly practiced; the temptations to it [are] great; and the impositions, indeed the robberies, to which insurers, in England, are thereby daily subject, [are] various and enormous...''

(Weskett 1781)

Agency Problems in 18C Marine Insurance

For Underwriters:• Moral Hazard: potential for fraud • Adverse Selection: merchants had better information about risks

Information (and “trust”) were crucial:• Ship arrivals & sailings• Political & military developments• Characteristics of the ship, captain & crew• Reputation of merchants and underwriters

For Merchants:• Underwriters’ Insolvency• Litigiousness: would they pay?

“An insurer ought to be constantly casting about for the earliest, the best, and the most circumstantial intelligence… in order to guard against concealments and misrepresentations…

it is far more material to him to regard the quality than the quantity of the risques which he undertakes.”

… and yet…

“with the keenest penetration and judgement, it will rarely happen that he is on an equal footing, as he ought to be, with the insured.”

(Weskett, 1781)

Timeline

1400s 1700 1720 1750s 1790s 1815 1844

Early underwriting in Italian City states

Private underwriting in Britain, France, Holland, etc.

Bubble Act (1720): two corporations chartered in London

Development of Lloyd’s

Timeline

1700 1720 1750s 1790s 1815 1844

Private underwriting in Britain, France, Holland, etc.

Bubble Act (1720): creation of 2 corporations in London

Development of Lloyd’s

Repeal of Bubble Act 1824

First attempts to set up marine insurance in America

Private underwriting in Philadelphia, New York, Boston, …

Movement to joint-stock corporations in America

Model

• Many merchants, who undertake voyages which fail with probability

• Successful voyages yield income I. (Failure yields zero).• Merchants have initial wealth W and VNM utility function u()

[u > 0, u < 0]

Order of play:• Merchants learn types ~ U[ , ] [0,1]• Merchants choose private or corporate underwriters• Private underwriters learn merchants types with probability ,

where

= the proportion of merchants who chose private underwriters• Private underwriters fail with probability > 0

Model

• Corporations premium = pc

• Private underwriters premium =

if is observed

pP otherwise

• Competition drives pc and pc to levels which yield zero expected profits

• Define

up(): the expected utility obtained by a type- merchant who chooses private underwriters

uc(): the expected utility obtained by a type- merchant who chooses corporate underwriters

Lemma 1:

For any given values of pP, and ,

up() < 0

For any given value of pc,

uc() = 0

Proposition 1:

Two kinds of (Perfect Bayesian) equilibria:

• All insure with corporations

or

• Good risks insure with private underwriters,

Bad risks insure with corporations (“lemons” logic)

Britain: A Lemons Problem?

“… it is impossible that the acting director or secretary of a [corporation], should possess the same knowledge, as to the nature and extent of every new description of risk, … as 1,500 underwriters, mostly men of commercial habits, and consequently commercial knowledge, daily collected together for the purpose of communicating and receiving intelligence … who concentrate the scattered rays of information, as it were, into one focus at Lloyd's. On this conviction the public offices, very wisely, refuse to take what they do not understand”.

(Hansard, Parliamentary Debates, 1810. Speech by Joseph Marryat).

Institutional Change (Equilibrium Selection) in the US:

Philadelphia premia during the Quasi-War with France

Institutional Change (Equilibrium Selection)

Equilibrium selection in Britain (?)

Equilibrium Stability in Britain: The War of 1812

Conclusion

• Multiple equilibria “Path-dependence” arising from

• Exogenous shocks• Bubble Act• US Revolution• Napoleonic Wars

• Endogenous evolution• Development of Lloyd’s in Britain: informal, later

formal• Role of learning