Humane Studies Review

The Rise and Fall of Fraternal Insurance Organizations

Bibliographic Essay

The fraternal insurance movement in America began in 1868. At this time, the insurance industry in America was young, and life insurance was a luxury reserved for the rich. This began to change, however, when a group of railroad mechanics from Readville, Pennsylvania formed a fraternal organization which had among its functions the provision of life insurance for its members.

The idea caught on, and by 1920 the National Fraternal Congress, an association of fraternal societies, boasted 200 member societies with 120,000 local affiliated lodges. These 200 societies insured nine million members with over $9,500,000,000 of life insurance in force.

The member societies of the NFC were just the tip of the iceberg. For example, we know that in 1918 there were 313 non-NFC fraternal organizations providing insurance to the immigrant poor in Chicago alone. In fact, fraternal insurance was by far the most popular type of insurance among the immigrant poor, as well as among native blacks. Despite their poverty, these groups had levels of insurance equal to, and sometimes greater than, native whites.

Fraternal organizations did not limit themselves to life insurance. Many provided protection against loss of income from sickness or accident. Some even provided medical care through "society doctors" on a fixed fee basis, much like today's HMOs. Also, many fraternals extended aid to their members even when there was no claim under the benefit rules, thus combining charity with mutual aid.

The fraternals appear to have peaked around 1920, but declined slowly until after the Second World War, and then began to decline precipitously. The story of their rise and fall is largely untold, presenting many opportunities for research and publication in a number of disciplines including history, economics, political science, and sociology.

General Historical Account
The American fraternal tradition had its roots in the British friendly societies. The friendly societies, in turn, were extensions of the medieval guilds, and ultimately of the burial societies of antiquity. For an excellent account of the evolution of the idea of mutual aid through the late middle ages, see Anthony Black's Guilds and Civil Society (Ithaca: Cornell University Press, 1984). There are also numerous histories of British friendly societies, including Self-Help: Voluntary Associations in the 19th Century (London: B.T. Basford Ltd., 1973) and The Friendly Societies in England 1815-1875 (New York: Augustus M. Kelly Publishers, 1967), both by P.H.J.H. Gosden.

In contrast, there are only two general accounts of American fraternal insurance. Walter Basye's History and Operation of Fraternal Insurance (Rochester: The Fraternal Monitor, 1919) provides a thorough history of the rise of fraternalism in America, as well as detailed information about the operation and regulation of their insurance function. However, because it was written at the height of the fraternals' power, it obviously does not chronicle their decline. A recent exploration is "Mutual Aid for Social Welfare: The Case of American Fraternal Societies," by David Beito (Critical Review, Vol. 4, No. 4 [Fall 1990]).

Although there is little written about the history of American fraternals in general, there are numerous histories of individual fraternal orders. There are also several assessments of the importance of fraternal insurance to certain communities embedded in general sociological surveys of those communities. Just a few examples include Homestead: The Households of A Mill Town (New York: Charities Publication Committee, 1910), in which Margaret Byington devotes a chapter to mutual aid among Slovak employees of the Carnegie Steel Company. There are other accounts of fraternal insurance among members of certain racial and ethnic groups, such as Mutual Aid for Survival: The Case of the Mexican American (Malabar, Florida: Robert E. Krieger Publishing Company, 1983) by Jose Amaro Hernandez. William Muraskin traces the history of black freemasonry in Middle-class Blacks in A White Society: Prince Hall Freemasonry in America (Berkeley: University of California Press, 1975). David Emmons has studied fraternals among Irish miners in The Butte Irish (Urbana: University of Illinois Press, 1989), and Lizabeth Cohen has researched fraternals among industrial workers in Making a New Deal: Industrial Workers in Chicago, 1919-1939 (New York: Cambridge University Press, 1990).

The good news for researchers with a quantitative approach is that fraternal insurance peaked during the progressive era, when the government was intensively gathering data on a variety of social issues. Toward this end, the government often performed budget surveys that tell us, among other things, how much insurance a subject bought and from whom. This makes possible numerous important studies using data gathered by state insurance commissions and bureaus of labor statistics.

Explaining The Rise of Fraternal Insurance: The Economics of Asymmetric Information
In order to explain the rise of fraternal insurance, we must ask ourselves what advantage these organizations may have had over commercial competitors. The answer to this question is likely to lie in the peculiar economic problems of insurance organizations.

Insurance contracts are made in an environment of asymmetric information. Simply stated, the insured has information about the probability that he will make a claim, information that is not so readily available to the insurer. Using the terminology of Kenneth Arrow's "The Economics of Agency" (in John Pratt and Richard Zeckhauser, eds., Principals and Agents: The Structure of Business [Boston: Harvard Business School Press, 1985]), the asymmetry takes two forms: hidden action and hidden information.

Hidden action refers to efforts taken by the insured that are not observable by the insurer, and that affect the probability that a claim will be made. For example, whether or not one smokes affects the probability that a health insurance claim will be made. But the insurance company is not in a position to observe this behavior. In fact, the availability of insurance may make the insured even more likely to smoke since the existence of insurance partially shields him from the consequences of his actions. The problems created by hidden action are referred to in the insurance literature as moral hazard.

Hidden information refers to facts known by the insured that are not observable by the insurer, and that affect the probability that a claim will be made. Suppose that a given population of insureds can be segmented into two groups, one with a high probability of making a claim, and one with a low probability of making a claim. Ideally the market would be segmented, with the high risk group paying more for their coverage. However, if because of hidden information it is impossible to tell which group a given insured belongs to, members of the high risk group would purchase the cheaper policy designed for the low risk group. The price of the low risk policy would rise as the number of claims increased, thus imposing an externality on the members of the low risk group. The technical term for this phenomenon is adverse selection. The classic work on adverse selection is George Akerlof's "The Market for Lemons" (Quarterly Journal of Economics, Vol. 84, No. 3 [1970]).

In order to explain the ascendance of fraternal insurance, then, we could ask whether these organizations had advantages over competing institutions in overcoming the problems of moral hazard and adverse selection.

The problem of moral hazard is studied by economists who deal with the principal-agent theory. For our present purposes, a principal can be defined as the party least likely to be informed in a transaction, in this case the insurance organization. The agent is the party most likely to be best informed in the same transaction, in this case the insured. (For further discussion of principal-agent theory, see Eric Rasmusen, Games and Information: An Introduction to Game Theory, New York: Basil Blackwell, 1989.) The trick, then, is for the principal to design a contract that will induce the agent to act in the principal's best interest. In the presence of moral hazard, a less than optimal contract can be designed that will balance the insured's need for insurance against the resulting disincentives. These second-best contracts will generally have certain characteristics. First, they will shift some of the risk back to the insured in the form of a "deductible," a portion of the total claim amount that must be paid by the insured. Second, the insurer will seek information from which he may infer the claims rate of the insured, and will attempt to monitor the insured to reduce inference errors. There is obviously a limit to what the insurer can obtain through these activities; certain information will be too costly to obtain, and certain monitoring procedures too costly to engage in. Two important works on optimal contracts in the presence of moral hazard are Stephen Ross' "The Economic Theory of Agency: The Principal's Problem" (American Economic Review, Papers and Proceedings, 1973), and Michael Spence and Richard Zeckhauser's "Insurance, Information, and Individual Action" (American Economic Review, Papers and Proceedings, 1971).

These developments in principal-agent theory will help to explain the ascendance of fraternal insurance if the fraternals possessed an advantage over commercial firms in the design of these contracts. Recall that the main techniques for designing the optimal contract, besides deductibles, are statistical inference of claims probabilities and monitoring. In the heyday of fraternal insurance, firms did not generally have available to them the sophisticated actuarial data that insurers use today to infer expected claims rates. So we would expect that monitoring would be the crucial factor in the overcoming of moral hazard during this historical era. And because of their relatively small size and cultural homogeneity, we could expect the fraternals to have an advantage over commercial insurers in monitoring the behavior of their members.

Adverse selection can be overcome if the integrity of risk classes can be preserved. We know that the fraternal insurance organizations were typically segmented along racial and ethnic lines. There were fraternals for native whites, native blacks, Poles, Slovaks, Hispanics, and for all the other ethnic groups that populated the urban ghettoes of early industrial America. During this era, we would expect these ethnic groups to have distinctive demographic profiles, and thus to form distinct insurance-risk classes. For example, we would expect members of a Slovakian fraternal in the Chicago ghetto to have similar jobs, similar family structures, etc. To the extent that the ethnic groups of the era formed distinct risk classes, the membership restrictions of the fraternals put them in a unique position to ameliorate the problem of adverse selection. (For a description of the proper risk classification and pricing of insurance, see Kenneth Abraham's Distributing Risk: Insurance, Legal Theory and Public Policy [New Haven: Yale University Press, 1986], and Gary Becker and I. Erlich's "Market Insurance, Self-insurance, and Self-protection," in Journal of Political Economy, Vol. 80 [1972].)

It is also possible to consider the problems of asymmetric information in terms of game theory. The classic game theory tool used to explore such problems is the "Prisoner's Dilemma" . It may be possible to model the decision of whether to cooperate (make only legitimate claims) or to default (make fraudulent or avoidable claims) in terms of this dilemma. For those readers unfamiliar with the Prisoner's Dilemma, imagine that you are one of a pair of prisoners, each unable to communicate with the other. Both of you are made the following offer: testify against the other prisoner and, assuming the other prisoner remains silent, you will go free (the other prisoner will receive a ten-year sentence). If you and the other prisoner both remain silent, you will each receive a one-year sentence. However, if you remain silent while the other prisoner testifies, you will receive a ten- year sentence (the other prisoner will go free), while if you both testify, you will each receive a nine-year sentence.

It is clear that the most rational thing would be for both of you to remain silent, thus gaining the minimum one-year sentence available to both of you. However, unable to communicate, you face two problems. The first is one of assurance: how can you know what the other prisoner will do? The rational thing to do, faced with this uncertainty, is to testify, thus assuring yourself of the smaller nine-year sentence in the event that the other prisoner testifies as well. But let's assume that you have avoided the assurance problem, by arranging beforehand how you would act if arrested, or simply because you know your partner well enough to know that he will not testify against you. You are now faced with the second problem, the temptation to become a free rider. In short, your knowledge that your partner will not testify leaves you with the opportunity to testify against him, thus gaining freedom at his expense. Because of the problems of assurance and free-riding, it is alleged to be impossible for individuals in this situation to behave in the most rational manner. (This is admittedly a sketchy definition of the Prisoner's Dilemma, and probably suffers from a lack of graphic representation. For a more thorough discussion of the model, and its relation to public goods in general, see David Schmidtz's The Limits of Government: An Essay on the Public Goods Argument [Boulder, CO: Westview Press, 1991], as well as the review of that book in this issue.)

The usual solution to the Prisoner's Dilemma, then, is that no one will cooperate. However, an interesting thing happens when we consider the case of repeated games. Prisoner's Dilemma-type defaults can be overcome in situations where individuals must interact on numerous occasions. Here a sort of "tit-for-tat" mentality may develop among participants. For instance, let's say that two people get together for the purpose of insuring each other against some possible tragedy. They agree that if this tragedy occurs to either or both of them, they will share the costs. If this tragedy actually does occur we might expect, based on the preceding discussion, that the non-afflicted party will at least entertain the temptation to default. What might keep him from doing so? Quite simply it is the knowledge that by defaulting he would eliminate any possibility for a long-term insurance relationship. There would be no chance of collecting from his partner if he himself should ever suffer a similar tragedy.

This dynamic becomes a bit more problematic when we consider groups larger than two. As the number of group members grows, and the number of transactions increases, the possibility of identifying defaulters would seem to diminish. However, the emergence of a phenomenon known as a "reputation mechanism" can eliminate this problem, by affording knowledge of an individual's transaction history and the likelihood that he will default. (For a concise exposition of the reputation mechanism see David Kreps, Paul Milgrom, John Roberts and Robert Wilson's "Rational Cooperation in the Finitely Repeated Prisoner's Dilemma," in Journal of Economic Theory, Vol. 27, 1982.)

Because of their small size and homogeneity, the fraternal organizations may have been in a better position to identify shirkers than were commercial firms. Also, members of fraternal organizations would be less likely to jeopardize their fraternal ties because the organizations performed other functions that they also valued. (For a broader understanding of cooperation from a game-theoretic perspective, see Robert Sugden's The Economics of Rights, Cooperation and Welfare [New York: Basil Blackwell, 1986]. Another innovative treatment of the prisoner's dilemma and cooperation is Schmidtz's The Limits of Government, op. cit.)

Explaining the Decline of Fraternal Insurance
At the height of fraternal insurance in America, consumers could choose from a wide array of insurance arrangements. In addition to fraternal insurance, a consumer could choose commercial insurance similar to what is common today. Industrial insurance, with premiums collected door-to- door on a weekly basis, was another low cost option for the workingman. Many trade unions also offered insurance. Today's insurance industry, however, is characterized by a much more restricted range of options. Indeed, consumers have very little choice in what has become a two-tiered system consisting of, first, costly commercial insurance usually linked to employment, and second, the government's "social safety net" . Disentangling the factors and processes that led from a situation with a considerable number of options to this restrictive two-tier system is a daunting task.

As you recall, it was suggested that the rise of the fraternals can be at least partially explained by their superior ability in handling the problems of asymmetric information. One possible explanation for their decline, then, is a diminution of these advantages relative to competing institutions. For example, one could argue that the cohesiveness of American communities declined with the emergence of our modern, mobile society. This would have the effect of diminishing the fraternals' natural advantage in monitoring. Also, the development of modern actuarial science would decrease the general importance of small-group monitoring in the insurance relationship.

The decline of community cohesiveness might also imply that the groups would no longer constitute distinct risk classes, so their advantage in ameliorating adverse selection would be undermined. This argument is especially strong for the ethnic fraternals formed by immigrant groups in the urban ghetto. We would expect the cohesiveness of these communities to decline as the immigrants assimilated.

However, just because the decline of fraternal insurance coincided with the decline of community does not mean that one caused the other. They may instead have occurred at the same time because they were both caused by another factor. Below are suggestions of some possible factors, though it should be stressed that here again is an area in which much more research is needed.

One such factor may be the rise of the modern welfare state. Fraternal insurance was especially popular among poor blacks and immigrants. This suggests that replacement of this insurance by mandatory or subsidized government social insurance may at least partially explain the decline of the fraternals among the poor. To what extent the fraternals were displaced by the burgeoning welfare state is not well documented. Social historians have noted, however, a general decline in community and mutual aid among the poor that accompanied the rise of the welfare state. David Beito, in the above-mentioned "Mutual Aid for Social Welfare," also points out that the introduction of workman's compensation has been linked to the dropping of disability insurance by many fraternals. Similar phenomena may be observed in the U.K. David Green has documented in detail the role of the National Health Act (providing state-financed medical care) in forcing out fraternals there. (See Working Class Patients and the Medical Establishment [New York: St. Martin's Press, 1985]. For a theory of the welfare state as a political strategy, see the Marxist-oriented essay "The Great Society as Political Strategy," by Frances Fox Piven, in Piven and Richard Cloward, The Politics of Turmoil: Essays on Poverty, Race, and the Urban Crisis [New York: Pantheon Books, 1974].)

Another factor that may have contributed to the decline of fraternal insurance was the imposition of wage controls by the federal government during the second world war. To get around these wage controls, employers offered benefits which were not considered taxable income (and hence not violations of the wage controls). These benefits came in the form of, among other things, health insurance. Because income is taxed and benefits are not, it is in the best interest of both employer and employee for the employee to receive as much as possible of his or her salary in the form of benefits, thus sheltering this portion of the salary from income and FICA taxes. This employer-provided non-taxed commercial insurance had a competitive advantage over other systems, and probably contributed to the decline of fraternal arrangements.

Still another factor that may have contributed to the decline of fraternal insurance is price regulation. By the 1890s, a movement was underway to impose a mandatory price structure on the fraternals. Beginning in 1891, the National Fraternal Congress themselves drafted a series of bills that, among other things, compelled all fraternals to charge rates no lower than those indicated by a mortality table they had computed. These bills were introduced into state legislatures for consideration. By 1919, 40 states had some form of NFC model bill in effect.

According to Walter Basye, the NFC did this in order to ensure that all fraternals were operating on a sound actuarial basis by setting a floor on the prices they could charge (History and Operation of Fraternal Insurance [Rochester: The Fraternal Monitor, 1919]). However, it is not known whether the fraternals were unsound nor indeed whether they had a significant insolvency rate. The fact that this legislation was promoted by the NFC, and opposed by the commercial insurance industry, suggests that the NFC was hoping to undercut efforts to bring fraternals under the more extensive regulation already in effect on commercial insurance firms. However, it could also be the case that the NFC was attempting, through the passage of this legislation, to promote cartel pricing. Here we have another group of issues awaiting the attention of serious and able scholars.

The economic effects of a price floor are well known. If the price floor is set below any price observed in the market, the price floor is trivial. But if some insurers are pricing below the floor, the low end of the market is eliminated. The imposition of the standard mortality table would most likely have the additional effect of flattening rates, both between fraternals and commercial firms, as well as among fraternals.

One last possible explanation of the decline of fraternal medical insurance particularly is medical licensure requirements. The fraternals provided health insurance by hiring a society doctor who provided care for members on a fixed fee basis. (This was also true of British and Australian friendly societies.) This practice came under heavy attack from the medical profession on the grounds that it was "degrading" to doctors and that society doctors were seriously underpaid. And because medical associations like the AMA in America and the BMA in Britain control the licensure of doctors, they were able to use their power to eliminate the practice. This process was documented for Great Britain in David Green's Working-Class Patients and the Medical Establishment, and for Australia in Green and Lawrence Cromwell's Mutual Aid or Welfare State (Sydney: George Allen and Unwin, 1984). (see note1)

There are, then, a number of competing explanations for the decline of fraternal insurance. Which of these explanations proves decisive will tell us a great deal about the ultimate significance of these institutions to the free society. If it can be shown that they were victims of displacement by the welfare state, or that they were regulated out of business, their decline is highly significant in terms of demonstrating how the government forces out institutions which would provide the same goods and services, but on a voluntary basis and more responsively to the needs of their constituencies.

Even if it turns out that the decline of the fraternals was a natural response to changing market conditions, their rise and fall is important in terms of understanding how a free society might work. In either of these scenarios, there is much to be learned from further study of the fraternal insurance industry. Historians and sociologists can look more closely at the conditions that lead to the rise of fraternal organizations, and how they functioned in the different groups in which they were found. How prevalent they were, and in how many different forms, are problems the solutions to which require further work. For political scientists and economists, there is the question of the effects of actions by the state, and why these actions were taken to begin with. Economists need also to look at the viability of fraternal organizations, and how they compare to the seemingly more limited range of options available today. So there is obviously enough work to keep scholars busy for some time, and the answers to these questions cannot help but give us new insights into the function of a free society.