Chances Are (18 page)

 

The Great Fire of September 1666 burns again in the clear, sympathetic prose of Samuel Pepys. This four days' disaster, the worst destruction London suffered between Boadicea and the Blitz, razed nearly 436 acres, devouring 13,200 houses, 87 churches (including Saint Paul's Cathedral), 44 livery-company halls, the Custom House, the Royal Exchange, and dozens of other public buildings. Only nine people died in the fire itself, but hundreds succumbed to shock and exposure.

Catastrophic urban fires were nothing new in a world lit by tapers and fed from open hearths. The refugees set up their rag tents and scrap-wood cabins in the fields beyond the walls. The King, as good kings should, promised cheap bread. A Frenchman conveniently confessed to starting the blaze and was expeditiously hanged. In all qualities save size, the Great Fire was just another disaster of the medieval or ancient world. What set it apart as an intrinsically modern event, however, is that Pepys' contemporaries could determine
exactly
what the damage was. Not “untold thousands of habitations” but 13,200; not “a dreadful holocaust of temples” but 87. This was not horror beyond the mind of man: it was a quantifiable event. A property-conscious, commercial, and thoroughly taxed city, London recorded itself to the last window and fireplace—and therefore knew exactly what was lost.

Indeed, it was this prickly Protestant self-awareness that prevented its being reborn as Europe's greatest Baroque city. John Evelyn, Christopher Wren's colleague on the redevelopment committee, had visions of an Italianate capital of piazzas, boulevards, and an esplanade along the river—but to create this would be to ignore the rights of individual property holders, before which a British government (then, at least) was powerless. John Ogilby was commissioned to make a map, 52 inches to the mile, of the devastated area: ironically, the very first accurate plan of any city in the world was a record of what was not. Armed with it, the authorities painstakingly reconstituted the street-plan, even the huddled house-plots, of the haphazard Roman-Medieval metropolis.

Building went ahead at enormous speed. Most houses were up within four or five years. Churches took a little longer: one can barely imagine the stamina of Christopher Wren, negotiating steeple-shapes with 87 Boards of Overseers simultaneously. A decade of uniform building and careful regulation in a populous city gradually brought London's fire risk under the dominion of the Law of Large Numbers. New outbreaks were no longer assumed to be the work of knavish Frenchmen or an angry God. They were scientific facts: exceptions that proved—that is, tested—a rule.

In 1638, just before the Civil War, London had petitioned Charles I for the right to offer fire insurance, but the idea had been forgotten in the greater tumults of the realm. Now, however, everyone saw the need—so, in 1680, a private joint-stock company opened its office “at the back side of the Royal Exchange,” offering to insure London houses against fire for a premium of 2½ percent of yearly rent for brick houses and 5 percent for frame; rent was assumed to be 10 percent of the house's value. The prime animator of this scheme was Nicholas Barbon, whose enterprise has left us the figures by which he estimated the risk his office could take on: in the fourteen years since the Great Fire, 750 houses had burned, with an average loss of £200. Seven hundred fifty houses, fourteen years—the average annual loss for all of London, insured or not, came to a little over £10,714 5s 8d hapenny. Let's assume, roundly, that Barbon's company insured half the City: 10,000 houses. Its likely annual payout would therefore be a little over £5,000, roughly 8 percent of the company's subscribed capital—a sum that could almost be met out of contemporary bank interest alone. Yet each insured house was paying Barbon a yearly premium (assuming £200 represented the average insured loss) of 10s for brick, £1 for frame. Even if every house were brick, £5,000 a year would come in to the office—which would
also
be sufficient to pay almost all claims. Potential loss was doubly covered: the scheme represented total security with the chance of exceedingly gross profit.

Profit
—you will notice that there is nothing about that in Bernoulli or Laplace. Theoretically, insurance distributes loss but shouldn't add to it. All other businesses attach themselves somehow to the productive element of human life: their profits derive, however tortuously, from the increase in value of all the world's goods. Insurance, though, is simply a reassignment of responsibility—and where's the productive element in that?

We could say that Barbon's profits were fortuitous, as there happened to be no more great fires; or that the small base of observations from which he worked made it necessary to calculate conservatively. We could say his investors deserved a reward for tying up their funds. Moreover, an average loss is not the
actual
loss; some years could require far more capital to cover pay-outs. We must say, though, that Barbon's conspicuous revenues changed insurance at its outset from a pure exercise in probability to the complex, devious institution it is today.

Two competitors arose almost immediately, each embodying a rival principle. The first was the government: within a year, London's Common Council had voted itself the right to issue insurance at rates slightly lower than Barbon's company. The courts speedily decided it had no power to do so, but the idea that our misfortune is properly the responsibility of the State (like our security, our employment, our health and our old age) remains a powerful one, countered in practice principally by arguments about the incompetence or untrustworthiness of governments.

The other new-sprung rival to the Fire Office was the Friendly Society, established in 1684 and followed twelve years later by the “Contributorship for Insuring Houses, Chambers, or Rooms from Loss by Fire by Amicable Contributions” (which is still in business, although now under the fashionably mock-Latin name of Aviva). These followed the mutual principle, which, in purist terms, has much to recommend it: there are no shareholders anxious for profit; the risk to be covered, moreover, is that of the actual members of the Society, not a haphazard selection of society at large. Just as, nowadays, women drivers constitute a lower accident risk than men and therefore can find lower-cost insurance, self-constituted groups—Quakers, Masons, Rechabites (organized teetotalers; also still in business)—could exploit the specific risk implications of their own peculiarities to offer themselves better terms. In Bernoullian terms, a self-selecting group needs a smaller
N
to bring its difference
|X/N
-
p|
within the degree of accuracy ɛ than does a random sample of humanity.

Supporters of profit-making joint-stock companies could counter that mutual societies cannot make speedy decisions and are always tempted to keep too little capital tied up; and indeed these and other arguments came to a head very quickly in 1687, when the Fire Office and the Friendly Society each petitioned James II for a monopoly on fire business. Typically, James came up with an arrangement that pleased nobody—alternate three-month exclusivity periods—but an afterthought to his decision added a new, complicating variable: he required the Fire Office to fund London's firefighting effort. The Fire Brigade was not to return to State responsibility until 1865.

The idea seems plain common sense: it is in an insurance company's interest to reduce its losses, so paying for firefighters is really just the company's own insurance policy. But it greatly complicates the issues of probability involved. First, each overall fire risk now constitutes two separate but related gambles: the chance a fire will start, and the chance it can be stopped before a total loss of the insured property. The chance of the first one is determined by probability, but its cost is variable and paid for directly by the policyholder; the chance of the second is variable, but its cost is determined, and is the company's, to be paid out of income. Moreover, the responsibility for putting out fires is very hard to restrict to insured risks: in the world's biggest city, it would have been foolish as well as immoral to wait until a blazing uninsured house had ignited the insured one next door before manning the pumps. Ultimately, the policyholders ended up paying for their neighbors' peace of mind as well as their own.

Returning to Laplace's principles, this almost off-hand royal decision had complex ramifications, all of which tended to increase moral fear. Compounding simple risk by associating it with prevention increased uncertainty, adding the fixed cost for fire prevention but an unknown return from that prevention. Giving the Fire Office a vague but undeniable responsibility for the security of the uninsured increased expense without reducing hazard. The only way to bring the moral impact of this uncertainty within mathematically acceptable bounds would be to increase capital—following the 10th Principle—and this soon became the great imperative of the industry.

 

The basic equations of insurance offer a measure of control over three ratios. The first is the ratio of observed cases to moral certainty—how many past events you need to know to be willing to bet on the future— which suggests that greater specialization can be more profitable. The second is the ratio of actual loss to insured loss—how much you can save from the wreck—which suggests that prevention is worth the expense. And the third is the ratio of potential loss to total capital—how hard any one misfortune will hit your reserves—which implies that bigger capital is always better. The manipulation of all three ratios has shaped the industry over the past three hundred years—and the abuse of each has brought its own particular disasters.

The success of fire and life insurance in the seventeenth century quickly spawned a multitude of specialist policies; and the increasing complication of life over the next two centuries encouraged the invention of many more. In the mid-nineteenth century, heyday of projector and prospectus, you could buy insurance “against bad debts or for bonds and securities in transit, against railway accidents, boiler explosions, earthquakes, failure of issue, loss on investment, leasehold redemption, non-renewal of licenses, loss of or damage to luggage in transit, damage to pictures, breakage of plate glass, loss of profits through fire, imperfect sanitation, birth of twins” . . . and famously, some time later, against damage to Betty Grable's legs. Each line of business required its own specialist expertise and its own collection of statistics to price the bet properly. Insurance against contract or bond default, for instance, became an industry on its own, particularly in the United States—the reason so many American financial companies have the word “fidelity” in their names.

The basic problem with specialist insurance is its very small
N
. Where specialization has an intrinsic advantage (insuring, say, Eskimos against sunstroke or Orthodox Jews against shellfish poisoning) the small number of observed cases is immaterial; but what about complex, important, expensive things that just don't happen very often? How do you price those?

Lloyd's of London learned a costly lesson about the dangers of a small
N,
when it first entered the satellite insurance business. From the 1960s to the early '80s, it had only one customer: the U.S. government, covering its commitment to the Intelsat consortium for satellite communications. Every launch was controlled by NASA, and every launch was different—in its technology, in its costs, in its inherent risk. High fluctuation, low correlation: the parallel with Marine insurance was obvious . . . so Lloyd's took the business.

In 1984, Westar VI and the Indonesian Palapa B-2 became stranded in low earth orbit, triggering a loss of $180 million—a loss so large that it was actually worth the syndicate's while to pay $5.5 million toward a shuttle mission to recover the satellite, repair, and relaunch it—all under the Marine insurer's age-old right of salvage. It also gave the early days of space commerce one of its odder images: a stout, pink, pinstriped underwriter at Mission Control in Houston, uncomfortably alone in a sea of crew-cuts, pocket protectors, and white drip-dry short-sleeved shirts.

Nor were Westar and Palapa the only payouts: between 1965 and 1985, total losses were $882 million, against a premium income of $585 million. Then came 1986, the
annus horribilis
in which the
Challenger
disaster was followed by successive failures of the Delta, Titan, Ariane, and Atlas launchers. As the industry lost, though, it learned:
N
and
X
were growing larger as each rocket left the pad. Bolstered by experience, satellite insurers are now much more confident in the pricing of launch insurance and are therefore free to worry about the parts of their business that still have a small
N
: solar storms, space junk, and dwindling orbital space.

 

Specialization begets expertise and expertise begets prevention: a company that must pay for disaster gains both incentive and opportunity to forestall it. The Fire Office may have had the responsibility to put out fires, but it was with the beginning of the Industrial Revolution that insurance companies actually began to shape the world into a less risky place.

Only by tiny, easily missed details of design and maintenance can a steam boiler be distinguished from a bomb.
Locomotion,
the very first successful railway engine, blew up and killed its driver—an ominous beginning. Steam had lurched suddenly and awkwardly from large, low-pressure installations like pumping water to small, high-pressure applications like transportation. The comfortable laissez-faire philosophy of early-nineteenth-century government made travel horribly dangerous—to the point where the Reverend Sydney Smith suggested that a minor bishop ought to give his life in a railway accident to draw attention to the problem.

As no bishop stepped forward, it was left to the insurance companies to deal with steam safety: money was a more efficient agent of social change than human life. The companies hired investigators to inspect and approve steam boilers; it was they who checked that the riveting was sound, that the tubes were clear, that no speed-hungry engineer had tied down the safety valve. Without certification, an engine could not be insured; and without insurance, it could not run—and could not kill.