Optimal Insurance Under Adverse Selection and Ambiguity Aversion

Abstract:     
In this paper we consider a model of competitive insurance markets under asymmetric information with ambiguity-averse agents. Individuals fail to estimate accurately their own accident probabilities and make their decisions based on intervals of possible probabilities. The interaction between asymmetric information and ambiguity aversion gives rise to some interesting results. If the low-risk insurees face sufficiently higher degree of ambiguity than high-risk insurees, there exists a unique pooling equilibrium where both types of insurees buy full insurance. If the equilibrium is separating, the low risks’ equilibrium contract is closer to their first-best one than under standard expected utility. Due to the endogeneity of commitment to the contracts offered by insurers, our model has always an equilibrium which is unique and interim incentive efficient (second-best).

Number of Pages in PDF File: 33

Keywords: Adverse Selection, Ambiguity Aversion, Endogenous Commitment

JEL Classification: D82, G22

working papers series