The first major risk management tool was insurance. The insurance industry had its origins in the ancient practice of bottomry, in which the owner of a ship borrowed money for equipping the vessel and, for a definite term, pledged the ship as security. If the ship was lost in the specified voyage or period, the lender (insurer) lost his money. Clearly, a rich lender had opportunities for diversification unavailable to the owner of a single ship. Bottomry is virtually extinct today, although the maritime insurance business (which lacks the lending aspect) that replaced it is alive and well. Bottomry was a remarkable development because the risk to the lenders could still be very significant in view of the massive potential losses from a single storm or pirate, whereas the ability to diversify these risks could be limited to the commercial fleet operating out of a single port. Interest rates must have reflected these risks.

The underwriting of accidental risk became an important business in 1771, when 79 underwriters pooled their activities and created the original Members of Lloyd’s. They would appear to have intuitively understood the value of diversifying their risks.

Benjamin Franklin set up the first American insurance company in 1752, writing fire insurance. Since then, a massive global insurance industry has developed to handle a host of relatively small risks whose occurrence is statistically predictable: Health and dental insurance, life insurance, fire and flood insurance, and automobile collision and liability insurance are examples.

These instruments are familiar because they work their way into most household budgets.