History of Insurance - Underwriting

The practice of underwriting emerged in the same London coffeehouses that operated as the unofficial stock exchange for the British Empire. In the late 1600s, shipping was just beginning between the New World and the old as colonies were being established and exotic goods were ferried back. A coffeehouse owned by Edward Lloyd, later of Lloyd's of London, was the primary meeting place for merchants, ship owners and others seeking insurance.

A basic system for funding voyages to the new world was established. In the first stage, merchants and companies would seek funding from venture capitalists. The venture capitalists would help find people who wanted to be colonists, usually those from the more desperate areas of London, and would purchase provisions for the voyage. In exchange, the venture capitalists would be guaranteed some of the returns from the goods the colonists would produce or find in the Americas. It was widely believed that you couldn't take two left turns in America without finding a deposit of gold or other precious metals. When it turned out that this wasn't exactly true, venture capitalists still funded voyages for a share of the new bumper crop: tobacco.

After the voyage was secured by venture capitalists, the merchants and ship owners would go to Lloyd's and hand over a copy of the ship's cargo to be read to the investors and underwriters who gathered there. The people interested in taking on the risk for a set premium would sign at the bottom of the manifest beneath the figure indicating what share of the cargo they were taking responsibility for (hence, underwriting). In this way, a single voyage would have multiple underwriters, who would try to spread their risk as well by taking shares in several different voyages.

By 1654, Blaise Pascal, the Frenchman who gave us the first calculator, and his countryman Pierre de Fermat discovered a way to express probabilities and, thereby, understand levels of risk. Pascal's triangle led to the first actuary tables that were, and still are, used when calculating insurance rates. These formalized the practice of underwriting and made insurance more affordable.

Source: Andrew Beattie is a managing editor and contributor at Investopedia.com.