Striking a balance

It started with a risk that limited opportunity. A new financial product was invented to hedge the risk. It was a bilateral contract that functioned by transferring risk from those unwilling to bear it to a market where investors could find additional yield and diversification.

The new market grew. Soon the contracts were not just being written to hedge those exposed to risk, but by participants who wanted to gamble on the exposure faced by others for speculative purposes. Increasing in complexity, the market was eventually overwhelmed by fraud and scandal, and legislators put a stop to the speculation. Restricted to its original hedging purpose, the financial product survived. It settled down to a humdrum existence, traded by conservative, risk-averse institutions.

No, not the credit default swap at the turn of the 21st century, but UK life insurance in the 18th century. The risk was mortality, striking in the prime of life and therefore a real hindrance to the individually driven economic initiative that was starting to turn Britain into a world power.

Who could question the value of life insurance as financial innovation? Yet from 1720 onwards, newfangled life insurance contracts were just as abused as many argue CDS contracts have been abused in recent years. A life was a 'reference entity' which could be insured multiple times, especially when celebrities such as royalty or politicians were involved. More insidiously, a large short interest in one's life became an incentive to murder that inspired the plots of gothic novels.

All this came to an end after the 1774 Gambling Act, and by the early Victorian era, the life office and its actuary had become the model of financial rectitude. Companies like the Prudential and Legal & General grew not by financial innovation but by industrialisation of the basic and conservatively applied idea. Similar conservatively minded companies sprung up in Germany and elsewhere in continental Europe.

But after the Second World War, the UK Labour government was creating a national welfare system, and it had the providers of private sector retirement provision in its sights. After all, if a life office collected premiums and invested them in government bonds, couldn't the state perform that function more cheaply, without the need to pay shareholders?

According to an official history of the company, the Prudential was so worried about this threat that it embarked on something it had never really had to do: financial innovation. The firm's actuary, Frank Redington invented what became known as the with-profits policy. It was a means of policyholders safely enjoying the benefits of share ownership via a terminal bonus. And it gave a crucial edge to the argument against nationalisation.

At the same time as inventing with-profits, Redington also invented insurance ALM, so the Pru never experienced any major problems with its innovation. Unfortunately, we know what eventually happened: Equitable Life turned the idea on its head and almost destroyed the UK with-profits industry as a result.

There is no need to emphasise the importance of risk management after a year like 2008. But at the same time, it's important not to dismiss innovation, especially at a time of regulatory retrenchment. The demographic risk management challenges of aging populations have not disappeared along with the ABS CDO. What we want to do is recognise innovation that has its place when coupled with good risk management, in the spirit of Frank Redington.