Insurance science and economics; a practical discussion of present-day problems of administration, methods and results

Front matter

INSURANCE Science and Economics

A PRACTICAL DISCUSSION

OF PRESENT-DAY PROBLEMS OF

Preface

The modern literature of insurance in all its branches, while quite extensive and practically valuable, is largely restricted to the consideration of matters relating to the office and field administration of insurance companies. Insurance, as a branch of contract law, has a literature of its own, which, however, is quite limited in its utility to the student of insurance questions and problems of the present day. As yet, only a few really useful works have been written in English on the larger and broader aspects of insurance in its relation to public policy and the functions of government arising out of the corporate nature of insurance institutions. Obviously, the conduct of the business cannot be called entirely successful unless insurance interests are intelligently co-ordinated to an enlightened public opinion demanding economical administration on the one hand, and absolute certainty of the fulfillment of contractual obligations on the other. Insurance today is an indispensable element of social and commercial life, and it is no longer exclusively a matter of local or state concern. The marvellous growth of the business within recent years emphasizes its national, and even international, importance and the duty of government to conserve the public interests represented by it to the fullest possible extent. The questions and problems discussed in the present volume are, therefore, not only of today, but of the future, and a matter of serious concern to all who hold responsible positions with insurance companies, or who, in some capacity or another, are required to express their judgment upon public questions involving insurance considerations. The problem of a more perfect development of the abstract theory and of a better practical adjustment of insurance to the varying needs of a progressive society, are inherent in the nature of the business, but their

PREFACE

successful solution lies largely with men of trained minds and impartial judgment, deservedly entitled to the full confidence of all concerned. The present work is, therefore, intended for the better and more adequate study of insurance as a branch of economics, while the large number of references appended to the several chapters will facilitate research work, where limitations of space have made a more extended treatment impossible. The bibliography includes most of the principal works on insurance, from the earliest times to the present day, useful for both theoretical and practical purposes, with a due regard to the historical development of the business and the complex problems arising out of its gradual evolution from the most primitive form of individual underwriting to a corporate business of colossal national and international magnitude.

For a full quarter of a century I have been actively engaged in the business of insurance, in the office administration, as well as in the field. My own extensive experience has forced upon me the conviction that one of the most serious shortcomings of insurance at large is the lack of proper insurance education on the part of many of the men who discharge responsible functions, as managers, agents, or other field and office employees. There are few textbooks of real value accessible to students in English, although many such are conveniently available to students of insurance familiar with German or French. The tendency on the part of the International Actuarial Congress, to become more and more a gathering of men interested in insurance science, after the manner of the German national society by that name, is a further indication that the modern trend of the business gives promise of better results in the years to come. The action of numerous institutions of learning which have introduced insurance courses, foreshadows a more deliberate and practical method of insurance education than has heretofore been possible, or thought necessary. It is, therefore, to be hoped that the present volume will be an aid in this direction and that the work will

PREFACE

prove useful to administrative officers, teachers, managers, agents, and others in sympathy with the larger aims and ideals of a business which is second to none in the civilized world.

Frederick L. Hoffman.

6 i Washington St., East Orange. N. J.

March 20, 191 1.

Introduction

Insurance as a science is properly considered a branch of economics, and as such it was included in the most recent authoritative classification of the sciences, adopted by the Congress of Arts and Sciences, held under the auspices of the Louisiana Purchase Exposition in 1904. At this congress two papers were read on insurance, the first on " Insurance as a Science," by myself, and the second, on " Insurance in Its General Aspects," by Prof. B. H. Meyer, now a member of the Interstate Commerce Commission.* Previous classifications of science had not included insurance, although as early as 1865 Dr. Engel, the director of the Prussian Statistical Bureau, had most ably presented the claims of insurance to scientific recognition before the International » Statistical Congress held that year in Berlin. The claim of insurance to the dignity of a science, however, is not new, for certainly as early as 1747 a small tract was published in England, by Mr. Corbyn Morris, entitled, "An Essay towards illustrating the Science of Insurance. Wherein it is attempted to fix, by precise calculation, several important maxims upon this subject; to solve various problems, and cases of contest; and particularly to balance, whether it be nationally advantageous to insure the ships of our foreign enemies." John Weskett, merchant, who in 1781 published an elaborate and classical digest " Of the Theory, Laws and Practice of Insurance," particularly emphasized its scientific aspects and observed that, " There is scarcely any other occupation, or profession, though far more unimportant, and less abstruse or complicate than that of insurance, amongst

* " Proceedings of the Congress of Arts and Science," St. Louis, Mo., 1904, in 8 vols. Published by Houghton, Mifflin & Co., Boston, 1906, Vol. VII, p. 207, et. seq the whole circle of arts and commerce exercised in this kingdom, where some method of instruction is not looked upon as requisite; and, where the persons employed in it are not prettywell versed in the grounds and theory, and the greater part of them expert in the practice of the principles on which it ought to be prosecuted: — but, one may venture to assert that, in no other class is there to be perceived so great a proportion of a numerous body of practitioners, who are so incompetently skilled in the nature of the matters about which they are occupied, and of the laws and rules, by which they ought to be governed, as amongst those who are in the actual employment of, and whose avocations and concerns are immediately connected with, affairs of insurance." What was true of this early period, when insurance was in its infancy, is equally true at the present time, that insurance education is generally neglected and upon even important matters of theory and practice there still exists much confusion and doubt, which only thoughtful consideration and painstaking analysis can set aside. The field of research is immense. The history of the business is largely unwritten and the works of classical writers are difficult of access to the student of insurance who desires to sustain his reasonings and conclusions by the same substantial foundation of knowledge as is required in every other branch of science.

Insurance as a branch of economics has also been much neglected by writers on political and social economy, but during very recent years there has been an awakening of interest in the economic theory of risk and insurance, which seems to indicate a more extended and qualified consideration of the subject in the future. It is still an open question as to which of the three general divisions of political economy — that is, production, distribution and consumption — should comprehend insurance, or whether the factor of risk assumption and distribution, through insurance, is not inherent in them all. The practical importance of such consideration is particularly apparent in the far-reaching issues involved in the question

vi whether insurance is commerce within the meaning of the commerce clause of the Constitution, although a number of decisions of the Supreme Court have heretofore been to the contrary. If economic theory sustains the conclusion that insurance is an element in the cost of production, and perhaps as much so in distribution, it is difficult to escape the conviction that insurance transactions fall properly within the scope of commercial undertakings, intercourse or trade, by whatsoever means or methods the same may be carried on. It requires no very extended research into the standard works on insurance theory, practice and law on the one hand, and commercial theory, practice and law on the other, to sustain the view that from the very earliest time insurance transactions have been considered, and invariably so, as being commercial transactions within the same meaning and scope as bills of lading, bills of exchange, and other negotiable instruments of various kinds. In the brief discussion of insurance as an element of early commerce only a few of the foremost authorities have been drawn upon, to avoid needless elaboration and wearisome repetition of detail. A discussion of insurance as an element of modern commerce would easily make a volume by itself, with a due regard to the numerous branches of insurance which have been developed within recent years. Their mere enumeration is sufficient to emphasize the practical commercial aspects of insurance as a necessary factor in mercantile adventure, commercial credit, and national advance. By way of illustration, reference may be made to through bills of lading, which include the assumption of risk on the part of the carrier in transportation by land, while long usage has required the assumption of the risk in navigation by the shipper and the general custom of covering such shipments by marine insurance.* Every through bill of lading, therefore, contains

* It is stated in the Compendium of the Official, Southern and Western Freight Classifications, published by the U. S. Dep't of Agriculture in 1910, that " The cost of insurance against marine risk will not be assumed by carriers unless specifically provided for in tariffs."

a special reference to the limited liability of carriers in this respect, while every invoice of a through shipment from inland points to places abroad includes a certificate of insurance for the full and necessary protection of the cargo against loss.

Reference may also be made to an important aspect of insurance in its relation to American shipping, for there is apparently much justification in the assertion of those who hold that the decline in the American merchant marine was in part the result of unfair classification by Lloyds of our ships during a critical period in the evolution of shipping, and furthermore that the American market for marine insurance is entirely insufficient for American needs.*

For the study and qualified consideration of questions and problems of this kind there is need of the accessibility of the classical writings on insurance, which are now extremely rare. Few even of those who have given much time and thought to the practical development of the business of insurance are aware of the wealth of literary material available for a history of insurance and a critical outline of the development of insurance theory and practice from the earliest times. Every student of law and legislation is familiar with the ancient maritime codes or sea-laws, of which the earliest is the Rhodian Sea-law, which during the last few years has been made accessible through the elaborate translation from original manuscripts by Mr. Walter Ashburner. All that there is contained in this fragment of law, which dates back to about 900 B. C, has its practical bearing upon modern methods of insurance, for the ancient doctrines of contributionship and average, jettison and salvage, maritime loans and other matters, are still held and applied in the courts of law of every civilized nation, including our own.

What Mr. Ashburner points out in his discussion of the Rhodian Sea-law is, unfortunately, true also of modern times,

* Hearings before the Senate Commission on Merchant Marine, Vol. I, p. 192 et. seq. Senate Report No. 2755, 58th Congress, 3d Session, Washington, D. C, 1905. See also the Report of the U. S. Commissioner of Navigation for 1890, p. 97 et. seq.

in that the ruthless destruction of commercial documents has deprived the students of law and legislation of much valuable material which is now irrevocably lost. A thorough study of insurance is out of the question until the works of the classical writers, the elaborate treatises by Magens, Molloy, Postlethwayt, Beeves, Weskett, Caines and many others are made accessible, and until even the still earlier treatises on insurance in Latin are made available in English as a necessary basis for a sound understanding of the ancient origins out of which the modern structure of insurance has developed. Early laws and ordinances dating back to the 13th and 14th centuries, are full of meaning even at the present day. Study of their provisions proves conclusively that from the very beginning of insurance as a business the insurance contract has been a matter of government supervision and control. Historical evidence is not wanting to prove that as early as 122 7-1 234 bottomry loans were prohibited by papal decree on the ground of their being contrary to public policy,* while as early as 1568 insurance was prohibited by the Duke of Alba as Regent of the Netherlands, f and contracts or agreements in various forms, wagering or gambling policies, etc., have been prohibited from time to time by different governments practically throughout the entire modern history of the business.

Insurance law as it is laid down in the commentaries of Blackstone and Kent, is not only an indispensable requirement in a full course of legal study, but it is equally valuable and necessary to the student of insurance in general. Kent, in his remarks upon the insurance contract and its gradual development through the course of centuries, observed, with reference to the value of insurance as an element of commerce:

"■ The business of uncovered navigation or trade would be spiritless and presumptuous. The contract of insurance protects, enlarges, and stimulates maritime commerce; and under its patronage, and with the stable security which it affords,

* Plass, " Geschichte der Assecuranz," Hamburg, 1902, p. 19. t Plass, ibid, p. 32.

commerce is conducted with immense means and unparalleled enterprise, over every sea, and to the shores of every country, civilized and barbarous. Insurers are societies of capitalists, who are called by their business to study with profound sagacity, and with exactness of calculation, the geography and navigation of the globe, the laws of the elements, the ordinances of trade, the principles of international law, and the customs, products, character, and institutions oi every country where tide waters roll, or to which winds can waft the flag of their nation."

A business of the magnitude of modern insurance is entitled to a literature of its own, a series of thoroughly digested text-books, a well established code of fundamental principles of law and legislation, and a national institute for promoting knowledge and developing the arts or methods by which sound theory can best be carried into practical effect. The time is slowly passing when the acquisition of new insurance through effective solicitation will constitute the chief consideration of success. Evidently it requires no argument however, to sustain the position of those who, during the formation period of the business, against almost insuperable odds, have adhered to the idea of aggressive solicitation even at considerable expense to advance the cause of insurance among every element of the population, from the poor and ignorant to the well to do and well informed. The insurance idea is subtle and difficult of clear comprehension except in actual commerce, where the necessity of insurance protection is so obvious and self-evident that it requires no argument or endorsement, as is made clear by the rapid growth of marine, fire, and other forms of property insurance, which are now quite generally made use of without the aid of much active personal solicitation. In life, accident, and many other forms of insurance, the difficulties in this respect are more serious, and the progress of insurance education is necessarily a slower one.

In the course of time, however, the insurance idea is becoming more familiar to the masses, and the sense of insurance obligations as a matter of personal or property protection tends to become subconscious, and indifference and opposition must gradually disappear. With increasing education and the spread of general knowledge on the one hand, and the imperative need of economic security against the casualties or calamities of life, on the other, the social necessity of insurance will become more obvious and the future growth of the business will be more and more the resultant of its own momentum. In other words, insurance, from being purely a form of business enterprise or associated effort for mutual protection, tends slowly but surely to become a social and economic institution, the evidence of which is met with to an increasing extent in so-called government insurance, or compulsory insurance, or quasi forms of insurance, state security and guaranty, which imperceptibly shade off into the theory and practice of true insurance. The most interesting proof of this assertion is to be found in the elaborate consideration on the part of an English parliamentary committee of a national guaranty for the war risks of shipping, which arose out of the previous considerations of a Royal Commission on the supply of food and raw material in time of war. It is a serious but common error to seek for insurance knowledge only among the readily accessible sources of information. It is, for illustration, only known to the very few, that the very stamp act which led to the American revolution included stamp duties upon policies of insurance.

It is also not generally known, if at all, that a corresponding act, imposing stamp duties upon policies of insurance, was passed by the U. S. Congress as early as 1797. The Annals of Congress, and even the Abridged Debates, by Benton, from 1789 to 1856, contain numerous and important discussions of insurance matters which are not even mentioned in the few historical works on insurance in the United States. In the Journals of the Continental Congress are contained a number of articles suggestive of proposals for annuity schemes as revenue measures to provide funds for carrying on the war of the Revolution, while the early messages of the governors of the different states contain important references to insurance of great historical and more or less practical value today. The proceedings of commercial associations often contain important deliberations upon particular phases of insurance, and the subject, among others, was brought before the Industrial Commission and the Senate Commission on the Merchant Marine. An able discussion of marine insurance in its practical relations to freight charges and the whole problem of transportation by water is contained in the report on that subject by the Commissioner of Corporations, while numerous cases on admiralty law, particularly the case of Insurance Co. vs. Dunham, abound with suggestive judicial opinion which have a direct bearing upon the further development of sound insurance theory and the perfection of the policy contract of insurance in all its branches.*

The most urgent requirement today is for carefully prepared text -books on insurance, and the correction or re-statement of discussions of insurance practice in text -books on arithmetic, and higher mathematics. The subject of insurance in its entirety requires to be taught in our leading universities, not primarily for the purpose of training men to become insurance managers, actuaries, or specialists in particular departments, but as a branch of science in the same sense and as physics, geology, chemistry, mechanics, banking, transportation, etc., are taught. The higher form of teaching is, however, out of the question until proper text-books are provided, in which the principles and elements of insurance shall be authentically set forth so that they may safely be used as evidence in legal controversies and settlements of differences of

* Among modern works which take cognizance of insurance as an element of commerce are, "Lessons in Commerce" by Gambroro and Gault, 5th Ed., London, 1904, and 'An Essay on the Early History of the Law Merchant," by W. Mitchell, Cambridge University Press, 1904. Among earlier works which should be consulted are, "Proceedings of the Commercial Convention held in Detroit, July, 1865," and "The National and Private Alabama Claims and their Final and Amicable Settlement", by Chas. C. Beaman, 187 1; also, "The Report of the Commissioner of Corporations on Cotton Exchanges," Washington, 1908, and " Sea Law and Sea Power," by T. Gibson Bowles, London, 19 10.

xii opinion concerning the proper meaning of particular terms. The general teaching of insurance as an element of commercial law as well as of contract law generally, requires also to be much improved, and the movement for uniformity in insurance legislation requires to be more actively fostered than has heretofore been the case. The pressing need of federal supervision of insurance ; of expert codification, and of equitable insurance taxation, are entitled to the most serious consideration, not only on the part of those engaged in the business of insurance, but of lawyers, merchants, bankers, economists, and others whose judgment and experience would aid in the solution of pending questions which at present are largely a matter of chance opinion and of drifting public policy.

Never before was there a time when insurance in its various aspects received as much public consideration as today. Questions and problems of old-age pensions, contributory schemes or retirement funds, workmen's compensation and employers' liability, government insurance, unemployment insurance, agricultural insurance, and industrial accident insurance, aside from the question of safe and economical administration of state chartered corporations, are now subjects of general discussion, committee hearings, legislative debates, and state action, with the practical certainty that more or less serious errors of material consequence will result from imperfectly considered plans or ill-considered schemes. The necessary aid must come from those who have seriously deliberated upon these questions and who bring a ripe knowledge and large experience to bear upon conclusions and recommendations as to what is and what is not compatible with the highest grounds of public policy. In this sense I would interpret the modern conception of insurance education as a branch of science and economics, as an important department of the common and statutory law, and finally as a proper subject for historical inquiry and qualified technical research.

Chapter I Life Insurance As A Science

The first inclusion of insurance in an authoritative classification of the sciences occurred in 1904, when the International Congress of Arts and Science, which met that year under the auspices of the Louisiana Purchase Exposition, assigned to life insurance its proper place as a branch of economics, which, broadly defined, is "the science of the relation between private property and public wealth." The honor of having been the first to assign a definite place to insurance in the science of economics appears to belong to Mr. Henry Dunning Macleod, whose conception of economics comprehends, first, material things; second, personal qualities, both in the form of labor and credit; and third, annuities. Most of the works on political economy and social science are barren of references to the third department, which, for want of a better term, Macleod defines as annuities, or "the right to receive a series of future payments." Such rights he terms "negative economic quantities," comprehending all mercantile and banking credits, checks, bills of exchange, terminable annuities, leaseholds, policies of insurance of different kinds, and many other valuable rights, amounting in value to thousands of millions of dollars, of which there is scarcely any! notice in the text- books on economics. He very properly remarks that by introducing this class of incorporeal property, he has doubled the field of economics.

To establish the relation of the science of insurance to the other great divisions of accurate and systematized human knowledge is the purpose of this discussion, and the more definitely this relation is established, the more clearly we shall comprehend the true nature, possibilities, and results of insurance as a vast and indispensable social institution of today.

Insurance, reduced to its simplest terms, means the application of the principle of association to the equalization of losses resulting from the inherent uncertainty in human affairs. This is the risk of untimely death, of fire, shipwreck, burglary, windstorms, floods, and many other contingencies outside of the control of man. The uncertainty of human life is modified by social progress, in particular by the advances in medicine and related sciences, but there must always remain the risk of premature death, which insurance alone can equalize through the principle of association. In the classic language of the first Select Committee on Friendly Societies, in 1825, it seems that "wherever there is a contingency, the cheapest way of providing against it is by uniting with others; so that each man may subject himself to a small deprivation in order that no man may be subjected to a great loss. He upon whom the contingency falls does not get his money back again, nor does he get for it any visible or tangible benefit, but he obtains security against ruin, and consequent peace of mind."

Theory op Risk and Insurance.

The theory of risk and insurance has been elaborated and set forth by Mr. Allan H. Willett in a most instructive dissertation published by Columbia University in 1901. He holds, and very properly so, that as a general rule uncertainty exercises a repellent influence in human life and that the existence of risk in an approximate static state causes an economic loss, while, on the other hand, the assumption of risk is a source of gain to society. From this point of view the business of insurance does not differ essentially from general commercial enterprises. Risk is assumed in mining and agriculture in much the same manner as risk is assumed in the business of insurance, but in life insurance, for illustration, the assumption of a risk and the equivalent premium payments required are determined by the theory of probability and the established laws of human mortality and observed experience. In general commercial enterprise the risk assumed is, as a rule created, while in insurance the risk assumed is pre-existing. This marks the broad division between gambling, speculation and insurance. Insurance is not "in the nature of a bet," for in insurance an effort is made to eliminate an existing risk by its assumption on the part of the many, while in gambling a non-existing risk is created with resulting uncertainty and needless loss to society.

The gain resulting to society is the reduction of the uncertainty for the group as a whole, or the substitution of certain loss for uncertain loss. By this process of diminishing the degree of uncertainty, the cost of the risk to society is very largely and considerably reduced, if not entirely eliminated, and thus it follows, in the words of Willett, that "the risk an insurance company carries is far less than the sum of the risks of the insured, and that as the size of the company increases, the disproportion becomes greater" ; or, to use the definition of Roscher: " The aggregate danger is less than the sum of the individual dangers, for the risk of it is more certain, and uncertainty itself is an element of danger." It is of the utmost importance that this point should be thoroughly realized by the statesman and the general public, so that from individual appreciation of insurance as a beneficent social institution may evolve the national appreciation of insurance as an institution making for the security of society and the well-being and effective protection of its members against the uncertainties of human life.

Applied Ethics.

At the outset we must consider the relation of insurance to ethics, for unless the business of insurance has the sanction of private and public morality it would be to no purpose to discuss its social and economic importance. One of the earliest objections to life insurance arose from the view that it was a form of gambling and that to insure one's life was not quite in harmony with religious duty. Even to-day a religious sect called the Dunkards object to life insurance on the ground that it has not biblical sanction, or at least, is not specifically enjoined as a duty by biblical authority. Few things, however, it would seem, are more readily susceptible of proof than that insurance must of necessity be included in the moral forces which make for the betterment of mankind, and especially for the gradual amelioration of the condition of the poor. Life insurance in particular appeals to man's moral sentiments, making for the protection and support of others at the cost of self-sacrifice and self-denial. So well has this been realized that almost from its earliest history we hear of the duty of insurance, until to-day this sentiment has become subconscious and a part of the conscience of civilized man, practically the same under conditions of poverty as under conditions of material well-being.

Much injury has been done to the cause of insurance by the unfortunate and unwarranted assumption that there is a fundamental identity between insurance and gambling. There is this much truth in the assumption, that the fundamental laws of chance and probability have at times and with great skill been applied to efforts at systematic gambling, but speaking generally, without much success. Gambling, lotteries, and kindred attempts to gain by the losses of others are intrinsically immoral in their results, while life insurance is intrinsically moral as a method and means for the advancement of mankind. Insurance advances progress, while gambling retards it. This fact is well brought out by Dymond in his Essays on Morality, and is indorsed by Wayland in his Elements of Moral Science. Dymond remarks, with particular reference to the duty of insurance against fire, that "the merchant who conducts his business partly or wholly with borrowed capital is not honest if he endangers the loss of an amount of property which, if lost, would disable him from paying his debts." To guard against this possible loss he holds that it would be unjust under such circumstances not to insure, for the majority of uninsured traders, if their houses and goods were burned, would be unable to pay their creditors. The injustice, in his opinion, consists in the taking of needless or unnecessary risk. Had life insurance in 1836, when this was written, been developed to the present extent of a universal provident institution, the Quaker moralist would, without question, have enjoined with even greater emphasis the duty of insurance protection for widows and orphans and self-protection against want in old age.