Lloyd’s of London is the oldest existing commercial insurance company, and it is an institution with an illustrious past. Originally formed in the eighteenth century to help merchants cope with the risks of commerce, it grew in the heyday of the British Empire into a mainstay of imperial trade.

The basic idea of Lloyd’s was simple. In the eighteenth century, shipping goods via sailing vessels was risky: the chance that a ship would sink in a storm or be captured by pirates was fairly high. The merchant who owned the ship and its cargo could easily be ruined financially by such an event. Lloyd’s matched shipowners seeking insurance with wealthy investors who promised to compensate a merchant if his ship were lost. In return, the merchant paid the investor a fee in advance; if his ship didn’t sink, the investor still kept the fee.

In effect, the merchant paid a price to relieve himself of risk. By matching people who wanted to purchase insurance with people who wanted to provide it, Lloyd’s performed the functions of a market. The fact that British merchants could use Lloyd’s to reduce their risk made many more people in Britain willing to undertake merchant trade.

Insurance companies have changed quite a lot from the early days of Lloyd’s. They no longer consist of wealthy individuals deciding on insurance deals over port and boiled mutton. But asking why Lloyd’s worked to the mutual benefit of merchants and investors is a good way to understand how the market economy as a whole “trades” and thereby transforms risk.

The insurance industry rests on two principles. The first is that trade in risk, like trade in any good or service, can produce mutual gains. In this case, the gains come when people who are less willing to bear risk transfer it to people who are more willing to bear it. The second is that some risk can be made to disappear through diversification. Let’s consider each principle in turn.