By Manavi Yamani

Abstract:

This article explores the historical and economic relationship between gambling and insurance, two activities often perceived as distinct. By examining their shared origins, underlying principles, and societal perceptions, we can gain a deeper understanding of the complex interplay between risk, uncertainty, and human decision-making. It also discusses the economic and psychological factors that underpin both gambling and insurance. The article delves into the economic and psychological similarities between gambling and insurance and draws on behavioural economic principles to analyse the concept of risk management, which is central to both activities and the role of risk aversion in decision-making.

Historical Context:

Gambling, as an ancient pastime, shares much with the origins of insurance. Maritime insurance practised by the Babylonians and Romans through bottomry agreements (foenus nauticum), is one such example. The marine insurance industry, which began sometime in the 13th-14th century, was initially perceived as a form of gambling, legitimised only when it was rebranded as ‘aleatory contracts.’ Early forms of insurance were closely intertwined with bets on the outcomes of voyages. For example, people would wager  whether a ship would return from its expedition, with crew members themselves sometimes contributing a small payment before departure. If the ship didn’t return after a certain number of days, it was presumed to have been lost, and the wager amount would be paid to the crew members’ families. Those insurers who consistently paid out claims earned a reputation that attracted more sailors to pay premiums before setting sail, turning a profit when most returned alive. The concept of insurance as we know it today, particularly maritime, fire, and life insurance, is rooted  in a class of gambling that began in Lloyd’s Coffeehouse. Initially designed for marine risks, other policies could also be taken out at Lloyd’s, such as fire insurance, which began the year following the Great Fire of London (1666). Their system required a payment of 30 shillings down to insure £100 for seven years.

Gambling and Insurance Through the Ages:

The earliest life assurance policies, like the one from 1583, involved a high degree of speculation, akin to gambling. Just as gamblers bet on outcomes, early underwriters bet on the life expectancy of individuals. 

As John Ashtonin, in his book The History of Gambling in England, notes:

“Nowadays, everything insurable can be insured. You can be compensated for accidents; if your plate glass windows are broken, if hail spoils your crops, or if your cattle die. The fidelity of your servants can be guaranteed. In fact, this field of permissible gambling is fully covered—whilst betting on horse racing rears its head unchecked, stock jobbers thrive, bucket shops multiply, and so do their victims.”

This highlights how the line between insurance and gambling has become increasingly blurred. The proliferation of insurance options makes it clear that risk has become a commodity, something to be bought and sold just like any other product. But while insurance is institutionalised and socially acceptable, traditional gambling continues to operate in a more shadowy realm, yet both thrive on the same basic principle: the management of uncertainty. He begins his final chapter with a striking observation: 

‘But, paradoxical as it may appear, there is a class of gambling which is not only considered harmless, but beneficial, and even necessary—I mean Insurance.’

In the early 18th century, the practice of ‘insuring a number’ in London Lottery shops — later known as the policy racket — emerged as a precursor to modern-day insurance. In this context, the term ‘policy’ wasn’t just a gamble; it was a form of cheap insurance. Players placed small bets on daily numbers in hopes of a significant return — essentially a wager on their future. As Herbert Asbury describes in Sucker’s Progress, this curious form of ‘insurance’ allowed individuals, often those who couldn’t afford a full Lottery ticket, to wager small sums on the outcome of a lottery draw. The clerks were dubbed ‘insurance solicitors,’ and the betting slips were referred to as ‘insurance policies.’

Insurance vs. Gambling: A Comparative Analysis

Gambling is economically not very different from the sensible mainstream concept of insurance. In many ways, insurance can be likened to gambling. When you take out property insurance, travel insurance, or similar policies, you’re essentially placing a bet with the insurance company that a specific event — such as the destruction of your property or falling ill overseas — won’t occur. Insurance is essentially the inverse of gambling. In this setup, the roles are reversed: insurance companies play the role of gamblers, while you are the casino. For instance, when you pay a health insurance company $2,000 annually, they bet that your medical expenses will not exceed that amount within the year. However, to cover their operating costs and ensure profitability, they must also include additional margins for administrative expenses and profit.

Consider Allstate, a major U.S. insurance company, collected approximately $44.2 billion in premiums in 2021 while paying out $35.1 billion in claims. While this figure doesn’t encompass all of their revenue and operational costs, it indicates that the financial odds are more favourable compared to a casino. For every dollar invested (in premiums), you get approximately 80 cents back in the form of claims — still a loss, but less drastic than the typical outcomes in a casino. According to conventional economic principles, both casinos and insurance companies should theoretically be unsustainable since they return less than they receive. However, insurance persists because it provides a structured method for managing and mitigating risk, despite the inherent financial trade-offs.

Behavioural Economics: Understanding Risk and Reward:

This can be better understood through the lens of Kahneman and Tversky’s ‘Prospect theory’. This theory posits that individuals value gains and losses differently, placing greater weight on perceived losses. People also tend to overweigh small probabilities, which leads to risk aversion in certain contexts and, counterintuitively, an attraction to low-probability, high-risk, high-reward scenarios. This psychological framework helps explain why individuals might prefer insurance to mitigate the risk of a large financial loss (despite its inherent cost) while simultaneously being drawn to gambling, where they bet on unlikely but high-reward outcomes.

In gambling and lotteries, people are often motivated by the possibility of a life-changing win rather than small, incremental gains. For example, a 5% chance of winning $100 is perceived as more valuable than a guaranteed $5, even though both have the same expected monetary value. This preference for high-stakes gambles, despite their low probabilities, reflects a psychological inclination towards monumental change over modest, assured outcomes.

Even when the odds are not in their favour, people are attracted to high-risk, high-reward scenarios (a game of blackjack once rescued FedEx from bankruptcy). For instance, when choosing between a small, certain loss and a chance of a larger loss, people tend to prefer the gamble if it offers the possibility of avoiding a major expense entirely. This is because they are willing to accept a small, guaranteed loss (like an insurance premium) to avoid a potentially catastrophic financial event, even if the actual likelihood of such an event is very low. At its most basic level, insurance is losing to avoid loss. Even if the expected financial value of insurance is negative, people may still be willing to purchase it to avoid the potential for a large loss. Both insurance and gambling involve risk, but they do so in contrasting ways. Insurance seeks to avoid a large financial loss by accepting a smaller, certain cost. In contrast, gambling involves accepting the risk of loss for the chance of a high reward. Insurance and gambling, while fundamentally distinct in their purposes and structures — insurance focusing on risk mitigation and gambling on risk-taking — both practices tap into our psychological tendencies outlined by prospect theory — overvaluing small probabilities and experiencing losses more acutely than gains.

Economic Relationship:

This concept is further explored by McGuire, Pratt, and Zeckhauser (1991) in their theoretical economics paper. The paper explores how individuals decide to spend money to improve their chances in uncertain situations, and whether these expenditures should be considered as gambling or insurance. The paper differentiates gambling from insurance by the nature of the outcomes and probabilities involved: gambling aims to increase the probability of a positive outcome while insurance seeks to reduce the probability of a negative outcome. It explores how a person’s level of risk aversion influences whether they view an expenditure as gambling or insurance. More risk-averse individuals are inclined to spend more to avoid bad outcomes (insurance) and less to chase good but unlikely outcomes (gambling). This highlights the psychological factors that influence decision-making in this context.

Conclusion:

Gambling and insurance fundamentally revolve around trading risk, though they are packaged differently. Both involve exchanging a series of small, guaranteed payments for a chance at a large payout. In insurance, the risk is transferred to the insurance company, while in gambling, the risk shifts to the gambler. Despite being similar transactions, the key difference lies in the participants. Individuals generally prefer to offload risk, making insurance, a transaction where risk is transferred to a large company—beneficial. Conversely, gambling, where risk moves from a large entity like a casino to an individual, is often seen as harmful. While insurance is a regulated product, gambling is frequently outlawed due to the potential for problem gambling and its associated social issues. While insurance operates on the principle of mutual aid, pooling risks for the collective benefit, gambling often devolves into a compulsive behaviour that becomes addictive for some, leading to significant personal and social harm. Behavioural economics offers valuable insights into the decision-making processes behind gambling and insurance. Applying these principles thoughtfully can enhance our approach to both risk management and promoting responsible behavior.

About the author:

Manavi Yamani is a final-year student at the Jindal School of Government and Public Policy, pursuing a B.A. (Hons) in Economics. Her research interests span Macroeconomics, Behavioral Economics, and Economic History.

Image Source: https://kriswilliams.medium.com/the-house-always-wins-casinos-and-insurance-companies-3e177be7a79b