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UNIVERSITY OF CALIFORNIA
AT LOS ANGELES




YALE READINGS IN INSURANCE
LIFE



YALE READINGS IN INSURANCE



LIFE INSURANCE



EDITED BY

LESTER W. ZARTMAN, PH.D.

ASSISTANT PROFESSOR OF POLITICAL ECONOMY, YALE UNIVERSITY





NEW HAVEN, CONNECTICUT

YALE UNIVERSITY PRESS

LONDON

HENRY FROWDE

OXFORD UNIVERSITY PRESS

1909



Copyright, 1909, by
YALE UNIVERSITY PRESS



Entered at Stationer? Hall, London



Printed in the United States



Library



o
I

O
2



g PREFACE

THE "Yale Lectures on Life Insurance" appeared five
years ago. Although a considerable edition was printed,
the unexpectedly large demand soon exhausted it, and as
the plates were destroyed, for two years the lectures have
been out of print.

*> It seems desirable that either a new edition of the lec-

N.^ tures should be printed, or that something new should be

published in their place. The latter alternative has been

chosen, and instead of simply reprinting the old lectures,

the plan has been adopted of selecting special readings,

partly from the "Yale Lectures," partly from other

sources. This plan was preferred for two reasons. In the

\ first place, many changes have taken place in the insurance

business since the old lectures were given, and much new

| and valuable material has appeared. In the second place,

" ! v it has been thought that by not confining the readings to

r* the old lectures a more comprehensive treatment could be

secured. In this way it has been hoped to broaden the

scope of the new readings, and thus to increase their

usefulness. Only four of the lectures included in the old

volume are reprinted, and three of these have been partly

rewritten. Some of the matter now published has never

appeared before, and much of the remainder has been

revised.

In selecting these readings, the aim has been to avoid
those authors who treat the subject in technical language,



vi PREFACE

as well as to avoid those who make the subject more simple
than it really is, and thus conceal its real problems. The
broad selection of material would not have been possible
without the cooperation of others. It is a pleasure to
acknowledge the fine spirit of publishers in permitting
reprints from copyrighted books, and the willingness of
authors to revise articles where changed conditions made
revision desirable.

LESTER W. ZARTMAN.

NEW HAVEN,

August, 1909.



CONTENTS

CHAPTER I



ELIMINATION OF RISK



CHAPTER II
FUNCTION OP LIFE INSURANCE 14

CHAPTER III
HISTORY OF LIFE INSURANCE; PERIOD OF EARLY BEGINNINGS 36

<y

CHAPTER IV
ORIGIN OF LIFE INSURANCE THEORY 46

CHAPTER V
J HISTORY OF LIFE INSURANCE IN GREAT BRITAIN .... 57

CHAPTER VI

HISTORY OF LIFE INSURANCE IN THE UNITED STATES ... 77

CHAPTER VII
THE THEORY OF RISK 97

CHAPTER VIII
MORTALITY TABLES 107

CHAPTER IX
ASSESSMENT LIFE INSURANCE 122

CHAPTER X
FRATERNAL LIFE INSURANCE 132

CHAPTER XI
NET PREMIUMS 155

CHAPTER XII
PROVISION FOR EXPENSES 175

vii



vni CONTENTS

CHAPTER XIII
RESERVE 183

CHAPTER XIV
NET VALUATION 192

CHAPTER XV
POLICY CONTRACTS 207

CHAPTER XVI
POLICY CONDITIONS 234

CHAPTER XVII
SURRENDERS AND LOAN PRIVILEGES 246

CHAPTER XVIII
EXPENSES FOR AGENTS 254

CHAPTER XIX
DISTRIBUTION OF SURPLUS 260

CHAPTER XX
DEFERRED DIVIDEND POLICIES 273

CHAPTER XXI
ECONOMIC ASPECT OF LENGTHENING HUMAN LIFE .... 287

CHAPTER XXII
CONTROL OF LIFE INSURANCE COMPANIES 299

CHAPTER XXIII

MISTAKES IN STATE REGULATION OF THE INSURANCE BUSINESS 312

CHAPTER XXIV
FEDERAL SUPERVISION OF INSURANCE 334

CHAPTER XXV
NECESSITY FOR REFORM OF LIFE INSURANCE TAXATION . . 363

CHAPTER XXVI
INDUSTRIAL INSURANCE 382

INDEX 399



YALE READINGS IN INSURANCE
CHAPTER I

ELIMINATION OF RISK 1

BUSINESS men try not only to estimate the risk which
they must encounter and to adjust their accounts accord-
ingly, but they also endeavor to avoid such risks alto-
gether. This follows from the existence of the factor of
caution. Where the coefficient of caution is abnormal,
amounting to mcaution, risks are not avoided, but are
expressly sought, and the phenomena of gambling and
indiscriminate speculation are the result. But in the
great majority of men there exists a healthy fear of risks,
and in consequence a tendency to avoid or reduce them.

There are five principal ways in which risks may be
reduced, viz.:

1. By increasing guaranties for the performance of
contracts.

2. By increasing safeguards against incurring losses.

3. By increasing foresight and thereby diminishing the
risks.

4. By insurance, that is, by consolidating risks.

5. By throwing risks into the hands of a special class
of speculators.

These will be considered in order.

The ownership of capital wealth necessarily involves

1 By Irving Fisher, Professor of Political Economy in Yale Uni-
versity. Reprinted from pages 288-300 of "The Nature of Capital
and Income," by special arrangement with the publishers, Macmillan
and Co., New York.

1



2 YALE READINGS IN INSURANCE

risk, since the income from it can only be estimated,
never precisely foreknown. But it is possible, by a divi-
sion of the ownership of capital wealth, for one class of
property holders to assume the burden of risks and to
guarantee to another class a fixed income. This is the
primary reason for the separation of securities into two
great classes called stocks and bonds. In any large enter-
prise the stockholders take the risks, and by so doing
guarantee to the bondholders a fixed income. As was
remarked in a previous chapter, the capital stock acts as
a buffer between the liabilities and the assets, which
amounts to saying that it guarantees a fixed income to
the holders of the liabilities. President Hadley has em-
phasized the fact that a bondholder "commutes" the pre-
carious income of an enterprise into a fixed annuity, and
that the system by which one class receives "interest" and
another "profits" has its origin in the desire of one class
to avoid and the willingness of another to assume risks. 1

Nevertheless the general relation between creditor and
debtor necessarily carries with it a certain amount of risk
to the creditor. This risk may be reduced by the deposit
of collateral security or indorsement 2 as in the case of
bank loans and discounts; by mortgage on real estate, or
occasionally on chattels; by legal regulations, as in the
case of notes of national banks, and by other methods.

1 But the "rate of commutation" is not a rate of interest, since any
ratio of commutation is necessarily a ratio between two incomes,
those respectively of the stockholders and the bondholders, whereas
the rate of interest is a ratio of income to capital.

2 The influence of indorsement in reducing risk is greater than
would appear on the surface. Thus, if there is one chance in a hun-
dred that the signer of a note will default, and a like chance for his
indorser, both these risks being independent, the chance that the bank
will lose is the product of these two, or only one chance in ten thousand.
Hence, two-name commercial paper is ordinarily a safe security, pro-
vided, of course, the names are those of reliable business men, such
as have a high "rating" in Bradstreet's or other standard commer-
cial agency.



ELIMINATION OF RISK 3

The method of guaranties is really a method of shifting
risks rather than of avoiding them. The second method
aims to reduce risk by special safeguards. Some articles
of wealth exist, in fact, simply for the sake of meeting
sudden unforeseen emergencies. This is true, for instance,
of fire engines, fire extinguishers, safety appliances on rail-
ways, safety valves, and other devices connected with
steam engines and machinery, burglar alarms, safety
deposit vaults, etc. To a large extent this risk-meeting
function applies to almost every stock of wealth. Food
in a pantry usually exists beyond certain wants in order
to provide for tmcertain wants, and when sources of
supply are distant, such stores of food need to be large.
Especially is this true in the case of armies. Again, a fac-
tory will usually have a large reserve stock, both of raw
materials and finished products, in order to meet unex-
pected demands. In like manner, jobbers, wholesalers, and
retailers maintain a sufficient stock of goods to meet not
only the foreseen, but some of the unforeseen demands
of their customers. The function of speculators in grain
or other commodities consists largely in conserving the
stock of a community as a safeguard against future scar-
city. Almost all of what is called the reserve of a bank is
used as a safety fund to meet the unforeseen demands of
note-holders and depositors, and, in particular, to meet a
special "run." These reserves often remain as idle as a
fire extinguisher for years or even decades against the hour
of need. It is said that there are bars of precious metals
in the Bank of England which have lain there undisturbed
for two centuries. A large part of the cash carried by an
ordinary individual is quite analogous to a bank reserve,
being held to meet special emergencies. Some individuals
even keep in a separate pocket a special gold piece, lest
some day they should become "stranded." It may be
said that this risk-meeting function of pocket cash is the
chief compensation for the so-called "loss of interest" on
the money thus carried. The convenience and security



4 YALE READINGS IN INSURANCE

obtained by having an adequate supply is a species of
income replacing the income which might be earned were
the sum invested. The same principles, from the stand-
point of an individual, apply to bank deposits, and thus
to the whole volume of the circulating medium.

The third method of reducing risks is by increasing
knowledge. It has been seen that risk is nothing but an
expression of ignorance, and decreases with the progress of
science. It may be said that the chief progress now being
made industrially consists in lifting the veil which hides
the future. The countless trade journals now in use have
their special reason for existence in enabling their readers
better to forecast the future, by supplying them with data
as to past and present conditions, as well as by instructing
them in the relations of cause and effect. The govern-
ment reports of crops, the technical schools and agricul-
tural colleges, all tend in the same direction. Whereas
formerly the mine prospector could only guess wildly at
the ore "in sight" and the time and cost required to mine
it, the graduate of mining schools is now able, through
knowledge of geology and metallurgy, to bring these fore-
casts into some degree of scientific accuracy. And,
whereas until recently farming was one of the most uncer-
tain of occupations, it is to-day thanks to modern scien-
tific agriculture almost if not quite as amenable to
prediction as industry or commerce.

We come now to that important means of avoiding and
shifting risks, called insurance. Insurance involves the
offsetting of one risk by another; that is, the_cpnsolidatioji
of changes whereby



^

js,asit jwere, manufactured out of uncertainty. To illus-
trate this, let us suppose that 10,000 houses of the same
kind are too distant from each other to be destroyed by
the same fire, and let us suppose that these houses in the
average would be worth $10,000 each were it not for the
risk of fire; in other words, that $10,000 is the capitalized
value of the services to be rendered by each house, assum-



ELIMINATION OF RISK 5

ing that it lives out its natural life. The value of the total
number of houses would then be $100,000,000. This is
the "riskless value." It is the capitalized value of the in-
come which the 10,000 houses would bring in, were there
no loss by fire. If interest is at 5 per cent., the income
which is thus capitalized is $5,000,000 a year. If now we
suppose that the annual risk of fire is one chance in 200,
there will be about 50 houses annually burned. Reckon-
ing the value thus destroyed at an average of $10,000 for
each house, there will be $500,000 annually lost by fire.
We must now deduct this from the $5,000,000, which
would be the income were it not for fires. We have left
$4,500,000, the capitalization of which is only $90,000,000.
In other words, the total property of 10,000 houses is
worth in "mathematical value" $90,000,000 instead of
$100,000,000, the reduction being because of the prospect
of fires. If we suppose all of these houses to be owned by
one corporation, this mathematical value of $90,000,000
might also be the actual value, for such a corporation
could count on about 50 houses burning annually almost
as a certainty. Each house would then be worth, on an
average, $9000. But if such an individual house is owned
by an individual person, this mathematical value would
not be its "commercial value," on account of the element
of caution. Let us say that the caution coefficient is ,
in which case the house would be worth $7000. In other
words, we have $10,000 as the "riskless" value of the
house, $9000 as its "mathematical" value, and $7000 as
its actual "commercial" value, assuming that there is not
as yet insurance. Now if the owner of such a house could
secure insurance on a purely mathematical basis of the
risk, which, as we have seen, is one-half of one per cent.,
and, therefore, could pay only $50 per annum, in con-
sideration of which the value of his house, if destroyed by
fire, is restored to him, it is evident that he has made a
good investment; for he is now assured of a house even
should a fire occur, and he has, instead of the risk of fire,



6 YALE READINGS IN INSURANCE

merely to pay his annual premium of $50 a year, the capi-
talized value of which is $1000. Consequently, his house
is worth $10,000 $1000, or $9000.

Such an insurance rate, however, being based on the
mathematical or "pure" premiums, would not pay any
profit to the companies conducting it. But even a higher
insurance would leave a large margin of capital-value saved
to the insured. If we suppose a "loading," so that the
insurance premium is not $50 but $100, similar reasoning
would show that the value of the house when insured
would be to the owner $8000 instead of $7000. As long
as the loading is not sufficient to absorb all the margin
between the $7000 and $9000, it will be advantageous to
insure.

Between the case of a man owning an individual house,
when the element of caution would have a large influence,
and that where 10,000 houses are owned by the same cor-
poration, in which case the caution element is almost
entirely absent, there are numberless intervening cases.
The larger the number of houses owned by one individual
or corporation, the less profitable becomes insurance. To
express it in the language of the business man, the various
risks insure each other. Thus, the North German Lloyd
Company finds it profitable not to insure its vessels against
shipwreck, because they have so large a fleet that their
losses through a period of time can be counted on fairly
well in advance.

One effect of insurance on the individual is to steady
the income from his property. The owner of the house in
question would receive, if it were not insured, a net annual
income, after providing for depreciation, of 5 per cent, on
$10,000, or $500 a year until the house was burned, after
which he would receive nothing; whereas, if he insures, he
receives this $500 income less his premium up to the date
of the fire, and afterward the income from the indemnity
paid him by the company.

The same principles apply to other forms of insurance,



ELIMINATION OF RISK 7

as marine insurance, which, by consolidating in an in-
surance company the risk on a large number of vessels,
reduces for the individual even the perils of the sea to
relative certainty and regularity; or as steam boiler insur-
ance, which in a similar manner treats the risk of explo-
sion; or as plate-glass insurance, burglar insurance, live
stock insurance, hail and cyclone insurance, fidelity in-
surance, accident insurance, employer's liability insurance,
and, above all, life insurance. This form of insurance,
like the other forms, tends to steady the income of the
beneficiary. If a wife holds insurance on her husband's
life, the consequence is that, although what he gives her
during his life is somewhat diminished, her income will
not suddenly cease at his death. The tendency of insur-
ance here as elsewhere is to make regularity out of irregu-
larity, relative certainty out of relative uncertainty; and
where, under the form of insurance contracts, the opposite
result follows, the case is not one of true insurance, but
tends to become one of gambling. Thus, if a person
insures the life of some one in whom he has no financial
interest, he is merely gambling on that person's life.
Some years ago in Michigan there was an abuse of this
type called "graveyard insurance." Speculators went
through the form of insuring the lives of certain old per-
sons, in other words, of betting on their deaths, a procedure
not only vicious as gambling, but calculated also to lead
to crime. The same considerations apply to fire insurance,
where a person insures a building in which he is not finan-
cially interested, or over-insures one in which he is. 1

The range to which insurance can apply is always
limited; but it is constantly being extended, as business
men learn how to bring risks of any kind on to a statistical
basis and to apply the theory of probability. At present
the total assets of life insurance companies alone in the
United States are nearly $3,000,000,000.

1 For the moral effects of insurance, see "Insurance and Crime,"
by A. C. Campbell, Putnam's, 1902.



8 YALE READINGS IN INSURANCE

Where risks cannot be reduced to a statistical basis,
and therefore cannot be insured against, recourse is often
had to the shifting of the risk into the hands of those who
are willing to take it. Such persons are speculators. A
speculator is usually one in whom the caution factor is
not so pronounced as in the ordinary individual. In ex-
treme cases he tends to become a simple gambler. The
distinction between a speculator and a gambler, however,
is usually fairly well marked. A gambler seeks and makes
risks which it is not necessary to assume, whereas the
speculator is one who merely volunteers to assume those
risks of business which must inevitably fall somewhere.
A speculator is also usually fitted for his work by special
knowledge, so that the risk to him, owing to superior fore-
sight, is at the outset less than it would be to others. The
indiscriminate prejudice against all speculation, which is
so often met with, is beside the point; for, were there no
speculators, the same risks would have to be borne by
those less fitted to bear them. The chief evils of specula-
tion flow from the participation of the general public, who
lack the special knowledge, and enter the market in a
purely gambling spirit. In addition to suffering the usual
evil consequences of gambling, they produce evil con-
sequences for the non-participating public by causing
factitious fluctuations in the values of the products or
property in which they speculate.

The evils of speculation are particularly acute when,
as generally happens with the investing public, the fore-
casts are not made independently. Were it true that each
individual speculator made up his mind independently
of every other as to the future course of events, the errors
of some would probably be offset by those of others.
But, as a matter of fact, the mistakes of the common herd
are usually in the same direction. Like sheep, they all
follow a single leader. How easily they are led is shown
by the effect on the stock market in the year 1904, when
Thomas Lawson published scare-head advertisements



ELIMINATION OF RISK 9

in the newspapers advising the public to sell certain
securities.

A chief cause of crises, panics, runs on banks, etc., is
that risks are not independently reckoned, but are a mere
matter of imitation. A crisis is a time of general and
forced liquidation. 1 In other words, it differs from any
other period in two particulars, viz., that the liquidations
are more numerous, and that they are for the most part
forced upon the debtors by the creditors because of threat-
ened or actual bankruptcy. Neither of these conditions
could exist unless there had been at a prior time a general
miscalculation of the future. Both creditors and debtors
must have made a wrong forecast when their ill-fated
agreements were entered into. Hence a crisis is the
penalty which must be paid when a previous general error
in prediction is discovered. Such a general error may be
due to the coincidence of a number of independent mis-
takes of individuals; but it almost always is due to lack
of independence, to the principle of imitation. The
error, whatever it is, when committed by a person of in-
fluence, is like an infection; it is caught by hundreds of
others and transmitted to thousands. A great mob of
easily led investors, eagerly searching for "straight tips"
which may bring instant wealth, make their mistake in
common, and when the mistake is disastrous they try, en
masse, to escape. A sudden rush of all the passengers on
a ferry-boat to one side will produce a "list" in the boat's
position, and sometimes cause it to capsize, though the
independent movement of the individual passengers will
seldom or never produce disaster. So also the sudden
general realization of unforeseen danger on the part of the
investing public may submerge the craft of credit and
those whom it has hitherto borne along in safety. In
short, a general crisis bears the relation to individual
bankruptcies which a general conflagration bears to

1 See Juglar, "Des Crises Commerciales," Paris, 2d edition, 1889,
Chap. I.



10 YALE READINGS IN INSURANCE

individual fires. The key to the study of either crises
or conflagrations is the existence, in place of independent
hazards, of interdependent ones. So far as conflagrations
are concerned, the principle of interdependence is dis-
tinctly recognized by students of fire insurance, and in
consequence each company strives to keep its own fire
risks independent of each other, by not having too many
in the same locality; but so far as crises are concerned, the
principle has not yet been sufficiently emphasized by
students of economic history.

The same principle applies to the phenomenon of a run
on a bank. The opinions of the bank's solvency are not
formed independently but interdependently. A year or
more ago the newspapers reported that, a policeman and
a crowd of people being collected on the steps of one of
the Wilkes-Barre savings banks to escape the rain, two
Hungarian depositors who were passing jumped to the
conclusion that the bank had been attacked by burglars,
and circulated the disturbing news in the Hungarian
colony, with the result that when the bank opened for
business many depositors made a run upon it.

We see, then, that where speculation is imitative, it is
dangerous alike to those who engage in it and to the pub-
lic. Where, on the other hand, speculation is based on
independent knowledge, its utility is usually enormous.
It operates both to reduce risk by means of utilizing the
special knowledge of speculators, and also to shift risk
from those who lack this knowledge to those who possess
it. The consequence is that normally speculative prop-
erty will gravitate into the hands of those most able to
forecast its true income.

Modern production has been called capitalistic-specu-
lative production, owing to the fact that it is managed by
"captains of industry," who are specially fitted at once to
forecast and to mold the future within the special realms
in which they operate. The industries of transportation
and manufacturing particularly are under the lead of an



ELIMINATION OF RISK 11

educated and trained speculative class, whose function
it is to assume for themselves the main risks, and leave
the ordinary investor, who is not so equipped, to cooperate
as a mere "lender" or silent partner. Yet it often happens
that they betray the confidence placed in them, and con-
tinue to throw the burden of risk on those whom they
pretend to shield.

In the special field more usually known as "specula-
tive," namely, that in which attempts are made to
forecast prices in the great exchange markets, we find
a similar class who are specially trained. These specula-
tors are either "bulls" or "bears"; that is, they speculate



Online LibraryLester W. (Lester William) ZartmanLife insurance → online text (page 1 of 33)