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.

(continued….)


To read the full article visit Prospect Magazine, where it was originally published in March 2017. It is based on a presentation given to the Worshipful Company of Actuaries.

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4 COMMENTS

  1. Excellent article, which I intend to put to immediate use in teaching my risk management classes. But in insisting on a dichotomy between “insurance, based on economic interest, and wagering for amusement,” I think it leaves out an important category — investment. If I buy a stock (or a basket of stocks), that is not insurance, since I don’t have any losses from the company I’m investing in doing poorly that I need to protect against. But surely it isn’t just “wagering for amusement”. Nor is it strictly zero-sum, as wagering on a sporting event is, since the economy will gain from the company putting my invested money to good use. But that opens up a host of other distinctions — what about taking on the risk of the stock through a derivative, what about shorting a stock — are these investments or wagers? And what does this say about other derivative positions, like credit derivatives and commodity futures? To what extent do they share societally useful characteristics of investments and to what extent are they just wagers for amusement? It’s not as simple as just seeing that they are not insurance.

  2. Kind of crazy to think that “subprime loans” could not go bad. Subprime loans on are subprime because the borrower is a higher risk client or the loan to value ratio is higher. And nobody thought that in mass these could go bad? Did nobody think the underlying value, the houses, could ever lose value? Geez, what a bunch of knuckleheads. The real estate market has historically gone up and down, and it’s greatly amplified by the FED. Also, the movie “The Great Short” is a good movie, see it.

  3. Equity issuance is essentially insurance by the original owners of the company, who are unwilling to take the whole of the risk associated with the business, and the investor is insurer of that risk . Secondary transactions may simply represent a sale of that contract to further spread the risk, as in reinsurance, or may be motivated by the original holder’s need for liquidity. But in modern equity markets, most transactions represent gambling – two different investors take a different view of the prospects for the same security. And a covered short is insurance, a naked short a wager.
    Tellingly, uberrimae fides applies to primary issuance but not to secondary market transactions.

  4. Wonderful article – just the right blend of fascinating historical detail and simple technical exposition. Small pedantic point: the Latin is uberrima fides (nominative) or uberrimae fidei (genitive) but not uberrimae fides. The adjective uber means fruitful, abounding (as a noun, it means a breast or udder), hence most abundant faith.

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