Adam Smith and Insurance

Adam Smith did not write about much about insurance but here are some thoughts and quotes that are connected.

Adam Smith on Risk

The contempt of risk, and the presumptuous hope of success, are in no period of life more active than at the age at which young people choose their professions. How little the fear of misfortune is then capable of balancing the hope of good luck, appears still more evidently in the readiness of the common people to enlist as soldiers, or to go to sea, than in the eagerness of those of better fashion to enter into what are called the liberal professions.

I think people miscalculate risk in every corner of investing.  Ego and pride put risk to the side and desire for glory blind them. Look at the investment management of any current insurance company. They put people’s life savings at risk, which will be bailed out by taxpayers.

To Adam smith insurance was good value:

The trade of insurance gives great security to the fortunes of private
people, and, by dividing among a great many that loss which would ruin
an individual, makes it fall light and easy upon the whole society. In
order to give this security, however, it is necessary that the
insurers should have a very large capital. Before the establishment of
the two joint-stock companies for insurance in London, a list, it is
said, was laid before the attorney-general, of one hundred and fifty
private usurers, who had failed in the course of a few years.

Adam Smith insurance, diversification

Adam Smith wrote on diversification:

Many sail, however, at all seasons, and even in time of war, without any
insurance. This may sometimes, perhaps, be done without any
imprudence. When a great company, or even a great merchant, has twenty
or thirty ships at sea, they may, as it were, insure one another. The
premium saved up on them all may more than compensate such losses as
they are likely to meet with in the common course of chances. The
neglect of insurance upon shipping, however, in the same manner as
upon houses, is, in most cases, the effect of no such nice
calculation, but of mere thoughtless rashness, and presumptuous
contempt of the risk.

The message is this:

Diversification is a type of self-insurance

Adam Smith makes a great point that diversification can protect against loss. Why then do so many investment managers ignore this. Sure they use simple diversification, but not true diversification.

Insurance | Wealth of nations

The UK was a seafaring nation. Adam Smith has an interesting commentary on Insurance.

Adam Smith in the Wealth of Nations wrote this on Insurance:

That the chance of loss is frequently undervalued, and scarce ever
valued more than it is worth, we may learn from the very moderate
profit of insurers.

This means people are usually underinsured, at least in 1776. But something else.  People underestimate financial risk.  I agree 100% with this. Look at the stock market or these mortgage securities. People treated these as 100% safe.

Smith on insurance:

In order to make insurance, either from fire or
sea-risk, a trade at all, the common premium must be sufficient to compensate the common losses, to pay the expense of management, and to afford such a profit as might have been drawn from an equal capital employed in any common trade. The person who pays no more than this, evidently pays no more than the real value of the risk, or the lowest price at which he can reasonably expect to insure it. But though many
people have made a little money by insurance, very few have made a great fortune; and, from this consideration alone, it seems evident enough that the ordinary balance of profit and loss is not more advantageous in this than in other common trades, by which so many people make fortunes. Moderate, however, as the premium of insurance commonly is, many people despise the risk too much to care to pay it.

Interpretation of Adam Smith an Insurance

I think the above quote on insurance speaks for itself. It is a metaphor for financial risk as a whole.  People do not understand it and play with fire.  I think many insurance companies even risk investment assets.  This amazes me.

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