Insurance in the Middle Kingdom (Without the Middleman)

As the nation with the largest population and second-largest GDP, China is often perceived as a land of vast economic opportunity, where entrepreneurs hawking the latest novelties of high technology operate alongside others peddling the tried-and-true amenities of more mature economies. In the latter category fall the property insurance products -- homeowners, business-owners, and transportation policies -- familiar for generations to those living in North America and Europe, but only now gaining a small foothold in the Middle Kingdom. Many observers of China's insurance market attribute the country's slow reception of these forms of insurance to cultural characteristics that will change as the country evolves. However, it is quite possible that conventional insurance is simply failing to compete against another, very ancient, financing mechanism: risk pooling -- insurance without the middleman.

To evaluate the potential of national insurance markets, analysts frequently employ the metric of "insurance penetration": the ratio of total insurance premiums to total GDP for a given time period. In 2010, China's property-liability insurance premiums constituted only 1.3 percent of GDP, compared to a figure of 4.5 percent for the U.S. Although China's property-liability market is overwhelmingly dominated by domestic companies, even these local insurers appear to anticipate that business will grow as cultural attitudes "modernize." In particular, it is expected that as economic relationships become more sophisticated, individuals and firms will abandon both (1) their traditional reliance on extended-family financial resources and (2) an ingrained fatalism that discourages planning for the perils of fire, wind, earthquake, etc. But what if both of these characteristics are actually more appropriate -- and even more "sophisticated" -- than the use of conventional insurance?

The notion of an insurance policy traces its earliest roots to the use of bottomry contracts in Babylonian society somewhat prior to the introduction of Hammurabi's Code (ca. 1772 B.C.). Under this type of arrangement, a land or marine trader would take out a loan of merchandise or money from a wealthy merchant, agreeing to a high rate of interest (usually at least 100 percent). If all went well, then the principal and interest would be paid at the end of the trading expedition; however, if the merchandise or money were lost or stolen, then the principal and interest would be forgiven. In short, the merchant was compensated for assuming the risk of the trading venture through the large interest payment.

A somewhat different practice developed among marine traders in ancient China (possibly as early as the use of bottomry contracts in the West, although firm dates are difficult to establish). Rather than simply transferring all risk from one party to another, groups of traders formed reciprocal arrangements in which each trader's store of merchandise was subdivided into small equal shares, each of which was carried on a different ship. In that way, no trader would be completely devastated by the sinking of one ship.

What is particularly interesting about these two approaches to financing risk is that each illustrates one of the two distinct characteristics of modern insurance. Specifically, the bottomry contract exemplifies the concept of risk transfer, in which one party cedes responsibility for an uncertain outcome to another party (who receives financial compensation for assuming the risk), whereas the Chinese mariners' arrangement embodies the concept of risk pooling, in which each member of a group cedes responsibility for shares of its own uncertain outcome to the other members of the group (who in turn are permitted to cede similar shares of their own risks). In conventional insurance, the policyholder transfers its risk to the insurance company, which then creates a for-profit pool of many policyholders. This naturally raises the question: What happens if the policyholders prefer to form their own pool, and avoid the costs of the insurance-company middleman?

Essentially, that is what the ancient Chinese mariners did; and perhaps what many Chinese individuals and businesses implicitly do today. Specifically, one could argue that a reliance on family financial resources -- basically the pooling of risks close to home -- is more economical than purchasing insurance. Similarly, one could interpret a fatalistic acceptance of certain risks as the institutionalization of high deductibles, which makes considerable economic sense in the presence of budget constraints and/or high premiums. In short, it seems reasonable to think of Chinese consumers as simply expressing a preference for informal risk-pooling alternatives to conventional insurance; and it is instructive to note that the broad formal use of risk-pooling mechanisms in more developed economies -- through self-insurance, risk-retention groups, and captive insurance -- is only a few decades old.