May that be through the practise of fractional reserve banking, issue of paper currency, bond market or stock exchange, the job of a banker has always been to induce as much money in circulation as possible. Through their genius and well thought out mathematical calculations, bankers have successfully accumulated all the wealth from society in their own hands. This has allowed them to invest even the savings of people which otherwise would have kept uselessly in their cupboards.
Another very genius innovation brought in to take every last bit of extra money left in people’s pockets was insurance. By exploiting the fearful nature of human beings, insurance has been made as necessary expense of the modern world as the purchase food items, and surprisingly it is paid most by the people living in the safest regions of the world. Ever wondered how this system took off?
Two ministers of a church in Scotland, Alexander Webster and his friend Robert Wallace, were the ones who deserve the credit for creating the first modern insurance fund back in 1744. The need for an insurance fund arose when the duo saw one group of people especially vulnerable to the consequences of unexpected deaths. The widow and children of a dead minister at Church of Scotland received only half a year’s salary in the year of the minister’s death and after that, they were left in poverty.
The plan Wallace and Webster came up to provide for them was ingenious. Rather than merely having all ministers pay an annual amount, which could be used to take care of widows and orphans when ministers died, they argued that the yearly payments should be used to create a fund that could then be invested profitably. Widows and orphans would be paid out of the returns on the investments and not just from the premiums themselves. Now all that was required for the scheme to work was an accurate projection of how many beneficiaries there would be in the future, a calculation which Webster and Wallace did with extraordinary accuracy.
Webster and Wallace gathered data of clergymen from all over Scotland. Their research showed that there tended to be around 930 ministers alive at all times and medium of last 20 years showed that 27 of 930 ministers die yearly. 18 of them leave Widows and 5 of them Children without a Widow. After series of trial and error, a fixed annual rate of ‘insurance’ was decided that was to be paid by all ministers. The money collected would then be used to create a fund that could be profitably invested to earn sufficient income to pay annuities to new widows and also to cover the fund’s management costs.
The Scottish Ministers’ Widows’ Fund was truly a milestone in financial history. It was based on correct financial principles and not just gambles rich merchants made prior to that. It established a model not just for Scottish clergymen, but for everyone who aspired to provide for life eventualities. Modern actuaries still marvel at the precision with which Webster and Wallace did their calculations. I certainly admired a lot the genius of people sitting in Silicon Valley until I came across statistical prodigies like Robert Wallace.
By 1815 the idea of insurance was so widespread that it was adopted even by the men who were to fight wars against Napoleon. A soldier’s odds of being killed at Waterloo were roughly 1 in 4. But if he was insured, he had the consolation of knowing that even if he is killed on the battle field, his wife and children would not be thrown out onto the streets.
In insurance size matters because the more people who pay into a fund the easier it becomes, by the law of averages, to predict what will have to be paid out each year. Although no individual’s date of death can be known in advance, but with the help of statistics we can calculate the likely life expectancies of a large group of people with astonishing precision using the same principles first applied by Wallace & Webster.
This brilliant system alone was not the reason why insurance is considered as one of the most important development in finance. What was achieved with the insurance money is what made it so impactful. Nobody anticipated back in the 1740s that by constantly increasing the number of people who participated in an insurance fund would make insurance a multi-billion pound industry. Large insurance companies have become, like banks, the mighty investors of the world — the so-called institutions who dominate global financial markets today.
As soon as the insurance companies were allowed invest in stock markets, right after the Second World War, they quickly owned a huge chunk of the British economy. By the mid 1950s they were sitting on board of around a third of major UK companies. Today Scottish Widows fund alone has over £100 billion under management.
Insurance was considered as yet another technique used to raise funds and invest for the gains of investors until one country made a very productive use of its sister innovation, the pension funds. They literally took their economy out of financial crisis by simply making its people open a pension funds account. The funds put aside by individuals to deal with the uncertainties of future, solved the nation’s financial crisis of present. Let’s find out how.
Miracle of Chile
By September 1973 the first ever Marxist president of Chile, Salvador Allende, made a complete mess of the country’s economy. His attempt to turn Chile into a Communist state ended in total economic chaos and parliament called military for a takeover. New government under the military dictator, Augusto Pinochet, was eager to stop inflation and rescue the drowning economy of the country.
Pinochet hired some young and well educated economists who suggested solutions for Chile’s economy. One such solution came from José Pinera to create a radically new pension system for Chile. He proposed a scheme where every person with a stable job was required to pay 10% of his income for pension fund. He argued that pension payments would not act just as small percentage of money kept aside by individuals for future, but when paid by every worker in the country, it becomes an income for the state that can be used to boost economic activity. To José Pinera, a state level large-scale system of insurance was simply a system of taxation. The idea was to give the Chilean workers a sense that the money being set aside was really their own capital.
By the end of 2006, around 7.7 million Chileans had a Personal Retirement Account. Specialists were hired to invest pension money in stock markets and they did a pretty good job with it. Average pension account had a return of 10% per year. And within 20 years, Chilean stock market had gone up by a factory 18. Fifteen years before military coup growth rate was 0.17 per cent and in fifteen years that followed, it was 3.28 per cent, nearly twenty times higher. The poverty rate has declined dramatically to just 15 per cent, compared with 40 per cent in the rest of Latin America.
Financial wizard have time and again proved to be of immense importance to various head of states. They have helped them during wars, bailing them out of financial crises or making ample amount of cash available for various ventures. But are these people really the financial messiah who saves nations from economic disasters and put them on path of prosperity? In the last chapter of this series we will discuss the ‘other side’ of these brilliant financial innovations. What have we lost in exchange for the material advancements that we have gained?
Read Next: The other side
Originally published at haq.life, Financial Innovations series is an essay divided in 7 parts which should be read in sequence for better understanding. Click on the links below to navigate to other parts of this series:
Table of Contents
