March 25, 2015

Drawing the Line Between Gambling and Finance:
Part V—Hedgers and the Law

Note:  This is the fifth article in a series looking at the legal connections between gambling and finance. The first article introduced the legal concept of aleatory contracts. Links to other articles in the series can be found at the conclusion of this article.

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Having looked at some of the more common aleatory contractsinsurance, reinsurance, and derivatives—and found strong parallels between those legally accepted contracts and various forms of gambling, it is time to return to the original question: Why are contracts like insurance and derivatives legal if they are fundamentally identical to gambling?

The short answer is that the law regarding aleatory contracts has long reflected a struggle to resolve the tension between the economic benefits of risk hedging on the one hand, and the moral and economic dangers of unbridled speculation on the other hand. This legal tension has spanned several centuries and been addressed across many cultures. The American legal system has traditionally taken a conservative approach to aleatory contracts, permitting those which show clear economic utility while being slow to permit or enforce contracts which resembled traditional wagers. But, as the American economy has evolved into a leader in the modern sophisticated global financial markets, the American legal system has likewise evolved to accommodate a broader array aleatory contracts.

The Historical Utility of Insurance
"This [New York City] has only been made possible by the insurers. They are the ones who really built this city. With no insurance there would be no skyscrapers. No investor would finance a building that one cigarette butt could burn to the ground."

~ Henry Ford
Insurance is the oldest form of legal aleatory contract, with some forms of economic risk pooling dating back to at least the ancient Babylonian empire; the Code of Hammurabi recognized a form of insurance protecting merchants' goods transported by ship or caravan against loss by storm or theft.

With the rise of the British Empire, insurance became an important and increasingly sophisticated part of international commerce as reflected in the founding of the famed Lloyd's of London underwriting syndicate. Interestingly, the close relationship between insurance and gambling was never far from the surface. As maritime insurance revenues fell, the Lloyd's underwriters turned to other lines of insurance, some of which—death by gin drinking, say—might raise a modern regulatory eyebrow. And the Lloyd's underwriters also turned to other, more traditional forms of aleatory contracts:
"Lloyd’s coffee house soon became notorious as a gambling den. An extract from the London Chronicle of the time [1768] stated: ‘The amazing progress of illicit gambling at Lloyd’s coffee-house is a powerful and very melancholy proof of the degeneracy of the times.’"
American insurance law, as might be expected, derives heavily from English common law. The American insurance industry was slow to develop in colonial times, mostly because the high risks of loss in the New World were deemed uninsurable by established British insurers. But, following the Revolutionary War, numerous American insurance companies were founded. Despite some moral opposition from conservative churches, the American insurance industry was doing robust business by the early 1800s; ironically, one of the first insurance corporations was organized by the Presbyterian Synod of Philadelphia to protect its ministers and their dependents.

The Economic Utility of Risk Hedging

The legal acceptance of insurance contracts is based on their economic utility; insurance is legal because it is economically important. The economic benefits of insuring against catastrophic loss are readily apparent. But insurance offers other, less obvious, economic benefits. For example, two of the largest expenses most people will routinely encounter are purchases of a house or vehicle. Generally, these purchases are made on credit, via a home mortgage or an auto loan or lease. Without insurance to protect their collateral, banks would be reluctant to offer credit on as favorable of terms. Instead, banks would require larger down payments (to limit the extent of possible losses) and would charge higher interest rates (to compensate for their higher risk of loss). In other words, insurance not only protects against large scale losses to homes and vehicles, but in many cases, insurance makes the purchase itself possible.

Similar principles apply in the commercial context. Without insurance, businesses would be reluctant to make large-scale capital investments in, say, buildings or machinery, if those investments were subject to loss because of fire or storm. To the extent businesses face uninsured risks of any kind—whether from fire, storm, theft, cyber-attack, lawsuit, or other cause—prudent financial planning will result in the maintenance of substantial capital reserves to cover those uninsured risks. Insurance, then, is not just a risk mitigation tool, but a method by which businesses can free up capital for investment into business operations.

Insurable Interests and Moral Hazards

Insurance, then, derives its legal status from its obvious economic utility. The ability of individuals and businesses to hedge against catastrophic risks not only protects those purchasing insurance, but also serves to lubricate the general economic machinery. But the law is careful to limit insurance to a hedging function through a concept known as insurable interest.

The insurable interest doctrine requires a party purchasing insurance to possess some legal interest in the object of the insurance policy. For example, an individual can insure his own life, but cannot insure his unrelated neighbor's life. Similarly, a business can insure its warehouse against fire, but cannot insure the warehouse of a competitor. Although the underlying insurance contracts in each case might look the same, the purpose of the contracts is fundamentally different. When insuring a life or property in which a person or business has a direct legal interest, the purpose of the insurance is hedging against risk of loss. When insuring life or property in which a person or business has no direct legal interest, the purpose of the insurance shifts to one of pure speculation. As the U.S. Supreme Court stated:
A contract of insurance upon a life in which the insured has no interest is a pure wager that gives the insured a sinister counter-interest in having the life come to an end. And although that counter-interest always exists, as early was emphasized for England in the famous case of Wainewright (Janus Weathercock), the chance that in some cases it may prove a sufficient motive for crime is greatly enhanced if the whole world of the unscrupulous are free to bet on what life they choose. The very meaning of an insurable interest is an interest in having the life continue, and so one that is opposed to crime. And, what perhaps is more important, the existence of such an interest makes a roughly selected class of persons who, by their general relations with the person whose life is insured, are less likely than criminals at large to attempt to compass his death.

Grigsby v. Russell, 222 U.S. 149, 154-55 (1911) (emphasis added).
In other words, absent an insurable interest, an insurance policy is nothing more than rank gambling, a wager on misfortune befalling a third party. Worse, the lack of an insurable interest creates an acute risk of moral hazard—specifically, the risk that an insured will destroy property or kill a person insured in order to profit from the contract. Regardless of whether a moral hazard actually arises, this type of speculation on the misfortunes of others is generally regarded as morally repugnant. The law, therefore, has long refused to permit speculative insurance contracts, and regards as void any insurance contract in which an insurable interest is lacking.

Gambling With Insurance

Interestingly, the U.S. Supreme Court ultimately ruled in Grigsby that life insurance is a form of property that can be assigned (transferred) to another person, even a person lacking an insurable interest in the underlying policy. In other words, the insurable interest requirement is satisfied by the initial purchaser of the policy, who is then free to sell the policy and its benefits to anyone. This ruling eventually led to the explosion of viatical settlements in the 1980s and 1990s, as individuals with AIDS sought to extract enhanced cash value from their life insurance policies by selling them to speculators who would pay below the policy's death benefit but above the actual cash value of the policy (which might be zero in a term life policy, or relatively small compared to the death benefit in a whole life or universal life policy). The speculator would pay the policy premiums, and would profit if the insured died early enough such that the policy death benefit exceeded the purchase price plus additional premiums. Viatical settlements are also common with other acute diseases with limited treatment options and short life expectancies, such as certain types of neurological diseases and cancers.

Similar to viatical settlements are life settlements, where an individual may sell to a third-party a life insurance policy the individual no longer needs. As with viatical settlements, the purchaser is speculating that the policy will "pay off" with the insured dying early enough that the death benefit exceeds the purchase price plus subsequent premium payments. Life insurance policies purchased via viatical or life settlements are sometimes bundled and securitized as so-called death bonds (essentially turned into an asset-backed security, as discussed in Part IV of this series). Because of the potential for abuse and fraud, most states tightly regulate viatical and life settlements. Nonetheless, viatical and life settlements are the one area where the law permits insurance to be used for speculation—specifically, "gambling" on the life of a stranger.

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Next up, discussion of the law's view of speculation.

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Additional articles in this series (links will be added as each section is posted):

Part I—Meet the Aleatory Contracts

Part II—Insurance: Gambling on Catastrophe

Part III—The Reinsurer, the Bookmaker, the Poker Pro Staker

Part IV—Derivatives and Daily Fantasy Sports

Part V—Hedgers and the Law

Part VI—Speculators and the Law

Part VII—Risk Creation v. Risk Management


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