The Disaster that Made Reinsurance

Favorable laws and institutions along with innovative practices helped put Britain at the forefront of the world insurance business for centuries. However, when it came to reinsurance, the British were sitting on the sidelines while the industry was thriving in Germany. As with many other historic changes in insurance, the birth of reinsurance resulted from a catastrophe. In 1842, a fire in Hamburg destroyed well over a thousand buildings. It also depleted a fund established by the city to insure against fires. However, the disaster did prompt the formation of the first specialized reinsurance firms.

English Model

At the beginning of the 19th century, London was the global center of the insurance trade. It owed this position to many innovations as well as laws offering a sound legal basis for insurance. It was London where the first known life insurance policy was underwritten in the 16th century. By that point, the city had also become a center for marine insurance, an industry that had previously flourished in medieval Italy, where insurance generally thrived. Indeed, the earliest known transfer of insurance risk in a secondary market survives in a contract signed in Genoa in 1370.

However, when marine insurers in Italy began to enter into transactions that were more akin to banking than insurance, they earned the scorn of the religious authorities there. In consequence, the industry moved north. In London, underwriters were organized around the city’s Lloyd’s insurance market. This began the English industry’s use of a market approach to writing policies, one where contracts were underwritten and even traded in by multiple individual underwriters acting independently. It wasn’t until the Great Fire of London in 1666 that insurance in Britain began to organize around firms. Indeed, by the early 18th century, London was home to some of the earliest insurance companies. The Great Fire of London was just one of the major disasters that has pockmarked the history of insurance ever since.

The market approach undertaken by English insurers allowed larger risks to be insured through a system of co-insurance, a model where several insurers each took a small part of a policy. Such a system was enabled by the Lloyd’s market. Using co-insurance, large risks could be shared by multiple underwriters operating in the same geography and product lines. Such a practice was similar to reinsurance in that it allowed for a broader spreading out of risk but did so at contract inception rather than in a secondary market.

Whatever its advantages, the model had its issues. For one, co-insurance meant that competing underwriters could learn a lot about the nature of each other’s books of business, something insurers were often uneasy with. Further, underwriters operating in the same geography usually had overlapping and correlated risks, limiting the diversifying benefit of co-insurance.

While co-insurance was the primary method for spreading risk between underwriters, reinsurance existed for a time as well, just not in specialized reinsurance firms. In London, until the mid-18th century, underwriters that originated a policy would often sell it on in the secondary market at a lower premium, pocketing the premium difference for themselves. This was a sophisticated trade; risks were sometimes split, with individual perils or specific amounts covered by different buyers. However, in an effort to curb excessive speculation in the insurance industry, this form of reinsurance was banned under the Marine Act of 1746. It remained outlawed until 1864.

“And be it further enacted by the authority aforesaid, that it shall not be lawful to make reassurance, unless the assurer shall be insolvent, become a bankrupt, or die” – Marine Act of 1746

Great Fire of Hamburg

Just as the Great Fire of London transformed the insurance business, so too did the Great Fire of Hamburg almost two centuries later. Of course, urban conflagrations were nothing to be surprised of and the city of Hamburg took precautions. Among these was the creation of the Hamburger Feuerkasse (or ‘Hamburg Fire Fund’), established in 1676. For Hamburg property owners in the city center, insuring property through the fund was compulsory.

Of course, an arrangement such as this concentrated a lot of exposure to the risk of fire in one particular city. To protect themselves, German insurance companies occasionally engaged in reinsurance contracts with other insurance firms. To avoid showing competitors too many details of a firm’s book, these were usually done with foreign companies, particularly those in France and Belgium.

The Hamburger Feuerkasse was nonetheless vulnerable when a fire burned down much of the city in May 1842. The fire lasted over three days, destroyed one-fourth of the city center, and killed 51 people. At least 1,700 buildings, mostly insured by the Feuerkasse, were total losses. This comprised 20% of the buildings insured by the fund. In total, the property lost was worth 100 million Hamburg marks ($35 million) and fire insurance policies written by the Hamburger Feuerkasse covered more than a third of these damages. The fund’s reserves were more than exhausted and it had to finance the losses by issuing a 46-year bond in the amount of 34 million marks to make good on its claims. The bonds were to be repaid by the introduction of a new municipal tax.

Reinsurance

The Great Fire of Hamburg was a wake-up call to the German insurance industry. Many small insurers came to appreciate the critical importance of spreading risk through reinsurance. At first, many continued to work with foreign insurance firms for this purpose, however, as insured amounts rose, this avenue for risk-sharing was increasingly exhausted.

That said, the creation of the first dedicated reinsurance firms was close at hand. For example, unable to obtain reinsurance abroad, the German insurer Niederrheinische Güter-Assekuranz-Gesellschaft turned to its shareholders to reinsure the company’s book of business. Taking up the company’s offer, shareholders set up a new company in 1842 to house this risk. Other companies made similar arrangements with their shareholders to create related reinsurance firms.

However, the first truly independent reinsurance firm was Kölnische Rück (or “Cologne Re”) founded in 1846. The formation of Cologne Re, championed by the entrepreneur and politician Gustav von Mevissen, was inspired by the Hamburg fire. The company was meant to satisfy the desire for a German reinsurance firm to compete with French and Belgian insurance companies that German insurers had previously turned to for reinsurance. However, there was another innovation. Because Cologne Re was purely a reinsurance firm and did not underwrite policies directly, clients would not need to worry about sharing information with a competitor or potential competitor.

New Paradigm

The advantages of reinsurance were clear. For one, like co-insurance, reinsurance allowed insurers to write bigger policies and limited the possibility of mammoth losses. With this ability, the size of the German industry grew rapidly. This growth helped insurers and reinsurers diversify risk still further. In insurance, growth in scale and scope facilitated further growth; the new reinsurance firms quickly developed global portfolios and operated across business lines.

The second half of the 19th century saw a proliferation of new reinsurance companies in Germany and Switzerland. By contrast, they would continue to be rare in the Anglo-American world where the co-insurance model survived. Urban fires continued to inspire the creation of new firms; the reinsurer Swiss Re was among these, founded after Switzerland’s Glarus fire of 1861. In Germany, there were a dozen reinsurance firms in business by 1870 and a dozen more were founded between 1871 and 1873.

Most of these firms no longer exist, though one that does is Munich Re, today an industry leader with an equity capital of €30 billion. It was found in 1880 with a mere 3 million marks though it expanded quickly, becoming the largest reinsurance company in Germany by 1884. It owed this success to novel practices intended to align interests between the company and its customers.

Aligning incentives reduced the risk of an insurance firm using its superior information about its exposures to offload only the risks offering the worst risk-return trade-off. One such measure meant to curb this practice was allowing customers to share in the profits of the reinsurance firm. Further, and probably more significantly, customers were required to reinsure entire lines of business rather than individual policies, limiting adverse selection.

Lesson

Though individual reinsurance transactions occurred long before the likes of Cologne Re and Munich Re were founded, the latter were dedicated reinsurance companies, something which did not exist until the mid-19th century. As with other innovations in the insurance industry, the reinsurance firm was born out of a catastrophic disaster, in this case, one that levelled much of a large European city. Whatever the losses sustained in the Great Fire of Hamburg, the lessons learned about managing risk in insurance have helped the insurance industry grow in spite of periodic disasters.

More from the Tontine Coffee-House

Read about another disaster in insurance history, the ‘Smyrna catastrophe’. Also consider this post about how insurance helped finance the construction of London’s bridges.