The Birth of Insurance Contracts - The Ataturk Institute for Modern ...

of hostile people, and to the investor, who risked loosing only the capital advanced. Commonly,
merchants received funds from several financiers, while investing in other merchants’ ventures for
the sake of diversification. Optimal Portfolio Selection theory can account for the merchant’s
reliance on external funds on the basis of managerial risk aversion, but takes the specific form of
contracts (securities) under which funds are raised as exogenously given. The Optimal Security
Design literature derives endogenously the characteristics of debt and equity under the assumption
that all contracting parties are risk neutral, but predicts the maximum investment participation
of the merchant to the venture (for excellent surveys of Corporate Finance, see Harris and Raviv,
1991, and Zingales, 2000). 3 However, the evidence indicates that medieval merchants both were
risk averse and resorted to external funds before investing 100 percent of their own wealth in
the sea venture they manage. 4 More importantly, neither the Traditional Capital-Structure
theories nor the the Optimal Security Design literature have addressed the evolution from the
securitization of the marine risk through debt-like sea loans and equity-like commenda contracts
to the provision of insurance, not through the capital market, but through premium policies.
The sea loan and the commenda differed from a combination of premium insurance and a
risk-free bill of exchange in two respects. First, both the sea loan and the commenda conferred
the merchant less protection against the marine risk than pure insurance contracts, which did not
only exempt the merchant from repayment beyond what was saved from misfortune at sea but
also provided a coverage payment to offset the merchant’s lack of gain in the event of a marine
incident. Second, whereas the sea loan and the commenda exchanged funds for a claim on the
venture’s returns, both the bill of exchange and the pure insurance contract established payments
from the agents’ personal wealth. Historical evidence suggests that enforcing these payments was
more difficult and costly than ensuring that the investor received a fair return from the venture.
The paper proposes a historically-grounded mechanism-design model of corporate finance with
3 The Costly State-Verification literatures explicitly recognized that standard debt contracts are not efficient if
the parties are risk averse (Townsend, 1978, p. ?, and Gale and Hellwig, 1981, p. ?). Under risk-neutrality, contracts
are optimally designed to minimize information and/or transaction costs. Therefore, the best a merchant can do
is to finance the project he manages in its entirety, unless restricted to rely on external funds because of budget
constraints and hence the prediction of a maximum inside participation rate to the firms’ investments.
4 Zingales (2000) and (1995, table IV, p. 1439) provides equivalent evidence on today’s entrepreneurs/firms.
3