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
For Merchants:
• Underwriters’ Insolvency
• Litigiousness: would they pay?
 Information (and “trust”) were crucial:
• Ship arrivals & sailings
• Political & military developments
• Characteristics of the ship, captain & crew
• Reputation of merchants and underwriters
“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
Early
Private
underwriting
underwriting
in Italian in Britain,
City statesFrance,
Holland,
etc.
1400s
1700
Bubble Act
(1720): two
corporations
chartered in
London
1720
Development of Lloyd’s
1750s
1790s
1815
1844
Timeline
Private
underwriting
in Britain,
France,
Holland,
etc.
1700
Bubble Act
(1720):
creation of 2
corporations
in London
Repeal of
Bubble Act
1824
Development of Lloyd’s
1720
First
attempts to
set up
marine
insurance in
America
1750s
1790s
Private
underwriting in
Philadelphia,
New York,
Boston, …
1815
Movement to
joint-stock
corporations
in America
1844
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