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Besides the general system of organization which results in a transfer of risk from capitalists and laborers to business enterprisers, specialization has produced numerous types of organization to which it is possible to transfer certain of the risks of business. Indeed, specializing in risk-bearing is one of the most striking phases of our modern differentiation of functions and functionaries. The most conspicuous illustration is of course the insurance company, but there are a great many others. Corporate suretyship, guaranty of real-estate titles, guaranteed collection services, and the hedging facilities offered by produce exchanges are illustrations.
 The assumption of risks for others looks at first like an extremely hazardous way of building an income. It is not necessarily, however, more risky than other forms of business enterprise, for the risk-bearer is usually better able to carry the risk than is the one from whom it is removed. This superiority may be due to superior knowledge of the situation, as when a title-guaranty company investigates a realestate title, satisfies itself that there is no real risk, and then guarantees the validity of the title. The owner of the property gets rid of the risk by transfer, the guaranty company assumes it, but reduces it to a minimum by research.
In a second class of cases the risk is transferred to a specialist who is able to reduce it by prevention. This is illustrated when an investment bank guarantees the sale of a bond issue, knowing that its own indorsement will assure the success of the flotation, or when a steam-boiler insurance company issues a policy to protect the owner of a plant and then furnishes an elaborate and efficient inspection service to reduce the hazard of loss. In a third class of cases the reduction of risk arises from the fact that the specialist who assumes the specific risk combines it with a great number of others and so reduces the amount of uncertainty, and hence the amount of risk through operation of the law of large numbers. This is the basic principle of most forms of insurance.
For all these forms of enterprise the chief hazard is not the hazard insured against, but the risk of failing to get sufficient business to furnish a working basis for the law of large numbers, or to repay the costs of organization.
It should be noted, however, that in all these cases the substitution of certainty for uncertainty effects a saving of indirect losses resulting from the event insured against, even though the direct losses are not reduced in number. Fire insurance affords a convenient illustration. Suppose that in the space of five years on an average 1 per cent of buildings of a certain type are burned and that the cost of selling insurance, keeping track of the business, investigating claims, etc., together with the profits of the insurance company, brings the cost of insurance on such buildings up to 2 per cent. Suppose A insures and B refuses to do so. It is evident that in the long run A will pay out twice as much for insurance premiums as B will lose by fires. But ff B has only one or two buildings, the "long run" necessary to make him fairly sure of this saving will be a great deal longer than his lifetime. Instead of saving the difference between the amount of the premiums and the average or normal loss, he gambles for the saving of a larger amount. If he is lucky enough to have no serious fires, he saves the whole premium. If his building is destroyed, he probably will never live long enough to save the amount lost out of his insurance premiums. Moreover, if he has his whole capital sunk in one building he has no chance to save any of the loss in this way until he has accumulated enough to put up another building. If the building is used for business purposes, moreover, its destruction is likely to mean not only the loss of the value of the building, but also the loss of business, good will of customers, etc. Part of this loss is unavoidable, but an insurance policy which enables one to rebuild quickly or to pay off debts which have been secured by the building may enable him to save a large part of this indirect loss.
One of the most important risks with which we have to deal is that which arises from the uncertainty of the length of human life. This takes two forms--the risk that one may live so long as to use up the funds which he has provided to support himself in old age and the risk that he may die before the end of his normal working life. Each contingency needs to be provided against.
The first is taken care of in large part by the method of reserves, the individual setting aside a part of his earnings as a provision for old age, a larger part in many cases than would be necessary if the length of life were known. The life annuity is a special device for taking care of this risk. This is a contract whereby an insurance company or other corporation agrees for a fixed sum to pay a given individual a stipulated income so long as he lives. For one who will live only an average period, the contract is not ordinarily an attractive investment, but it relieves him of the risk of using up all his savings and coming to want because of an unexpectedly long life. The pure endowment is another contract which insures against a risk arising from the length of life. It is similar to an annuity except that the person taking out the contract pays his money in annual instalments for a term of years, and at the end of that time receives a lump sum. If he dies within the stipulated time, nothing is paid by the company. Such contracts have been used in Europe by parents to provide for the expense of higher education of their children, or to provide dowries for daughters. Endowment-life policies combine pure insurance and pure endowment in one contract.
The second type of risk connected with human life is the risk of death before one's normal working life is completed, with consequent loss of earnings. The way which this risk is shifted to insurance companies will serve as an illustration of what we mean by the elimination of risk through specialization and combination. For the individual, there is nothing more uncertain than the duration of his life. For the insurance company, on the other hand, the insurance contract involves very little risk. Which of the insured will die no man knows; how many will die, if the number of insured is large, can be predicted with great accuracy. Hence the company can profitably sell the insurance at a price at which it is a good bargain for the insured.
Outside the fields of fire and life insurance, the most important branch of the insurance business is marine insurance. Newer types which are gaining rapidly in popularity are burglary, plate glass, automobile, and credit insurance. In all these cases, the principle is the same. If a business has a large enough number of risks and if the risks are independent of one another, it is likely to be cheaper not to insure, for unless the insurance company receives a great deal more in premiums than it pays out for losses it cannot continue to do business. A railroad company need not insure its station buildings, and a large business owning many buildings with plate-glass windows need not insure them against breakage. The amount paid out in premiums will be greater than the amount needed to replace the damage. In the same way, a large number of small risks of different kinds may be allowed to offset one another. Wherever such a distribution of risk cannot be secured, however, assuming that the expense loading and profits of insurance companies are not excessive, all insurable risks should be insurance against, for the insurance company, having a wider distribution of risk, can definitely count on a smaller variation in the number of losses than can any one individual, and hence can get along with smaller reserves withdrawn from active business use to guard against the impairment of working capital.
The field covered by insurance companies, however, is much narrower than the field of risk involved in carrying on business. For a risk to be well adapted to insurance and elimination by combination, two conditions are necessary. There must be available for insurance coverage a large number of independent risks, and the probability of the occurrence of the event insured against must be known with fair accuracy. If the first condition is absent the insurance is speculative; if the second is absent it is impossible to determine a fair rate, as the combination of risks does not afford knowledge as to the total losses to be anticipated. Insurance under either of these conditions involves simply a transfer of risk from one individual to another, without reduction, and is speculative in character. To meet the need for insurance or for protection against various types of loss where no statistics are available from which to calculate the expected loss, or where no proper distribution of risk can be obtained, the Lloyd's type of speculative insurance has been developed. In this type of contract, a large group of private insurers enter into a contract by which they agree to recompense the insured for his loss dividing the cost between themselves. For example, people in Washington owning property along the line of march of the inaugural procession sometimes insure themselves against loss from bad weather on the fourth of March through the London Lloyd's. The insurers in this case may secure a distribution of risk, in spite of the fact that if they have a loss on one policy they will have a loss on every policy of this type. This is done by diversifying the contracts. If the individual insurer writes many policies and none are large, he secures a combination of risks which protects him against excessive loss. But there is a large speculative element involved in the fixing of the premium rates. Protection against drought is of this character. So long as such policies are written to cover a bona fide risk and not for speculation, they are as useful as any other type of insurance, but the device obviously lends itself admirably to gambling and is often used for that purpose. In the earlier days of life insurance, it was permissible for anyone to take out insurance on the life of anyone else, and policies practically of the Lloyd's type, on the lives of public men were often taken out purely for gambling purposes.
Very similar to the speculative type of insurance is the practice of hedging. This is the practice of making two contracts at about the same time of an opposite, though corresponding, nature--the one in the trade market and the other in the speculative market. The same possibility of using a contract either for the purpose of hedging a legitimate risk or for the purpose of creating a gambling risk which we say in the Lloyd's contracts arises in connection with these "future contracts" on the produce exchanges. When a grain merchant sells a future contract to hedge against a fall in prices while he is marketing his purchases of cash grain, or a flour-miller buys a future contract to protect himself against loss while he is manufacturing flour which he has agreed to deliver, they are securing protection against a definite risk in much the same way that one secures protection against unknown hazard through Lloyd's policy, but in both cases the only way that the insuring or hedging individual gets rid of his risk is by transferring it to someone else who assumes it as a speculation. The whole machinery of the produce exchange finds its justification in the facilities which it affords for carrying on certain types of business with a minimum risk and consequently at a minimum cost. There is no question that it is sound business policy to make use of the hedging market wherever a hedging contract can be secured on reasonable terms, but the existence of a hedging market presupposes the existence of a group of speculators who are taking the risk off the business man's shoulders, and there has as yet been found no way to keep these contracts from being bought and sold in a purely gambling spirit.
Another way of transferring risk is what is known as "contracting out," a method similar to hedging, but not involving the use of a speculative futures market. Contracting out may be explained briefly as follows:
The work of the organized exchanges has certain sensational elements, and volumes have been written upon these exchanges where sentences have not been written upon the vastly greater volume of speculative contracts entered into outside the limits of the organized exchange. These speculative contracts are so well known that a simple illustration will suffice. I decide to build a house. A contractor assumes the task. He then proceeds to make sub-contracts with the purveyors of lumber, bricks, and other materials to the effect that these materials shall be delivered to him at a certain future time and at a certain price. The main contractor has thus contracted himself out of risk with reference to price changes in these materials.
Our contractor has thus been relieved of much of his risk.
The foregoing illustration is typical. A man agrees to do a certain thing. He then contracts himself out of certain phases of the risk involved. True, the burden is merely transferred to someone else, but presumably this someone else is a specialist, and therein is the social defense.
In the building industry and in some lines of manufacturing, it is practicable to pass on in this way the risk of price changes in nearly all the important cost items except labor; this latter risk the manager must ordinarily himself assume if he contracts in advance to sell his product at a given price. During the war, however, it was not uncommon for building contractors to rid themselves of this risk by stipulations that the contract price should be readjusted in case changes in wage rates should occur before the completion of the job.In many lines of commercial and manufacturing enterprise, risks can be passed on by coupling advance sales with advance purchases; in other lines, the risks must be assumed but can be kept at a minimum by keeping inventories and advance orders low. Quick turnovers give relatively little chance for profit or loss from price changes.It is usually the case, however, that at some point in the chain of successive buyers and sellers the possibility of contracting out or coupling purchases and sales disappears. Someone must assume the risks; the fact that the one who assumes them is a specialist means that he has superior facilities for judging the situation, if a basis for judgment exists, but it also means, as a rule, that he does not secure a good distribution of risks.
QUESTIONS
1. Does insurance reduce risks or does it transfer risks from the individual to society?
2. Should a state carry insurance on its buildings?
3. B, a dealer, has 500 automobiles in stock. Should he insure them?
4. Give some examples of cases when it is cheaper to run risks than to avoid them.
5. Should the amount of the insurance carried on buildings depend on their cost or on present cost of replacing them?
6. C is supported by the income from his wife's property and does not work. Should his life be insured? Should his wife's life be insured in his favor?
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