Information Design in Insurance Markets: Selling Peaches in a Market for Lemons

Abstract

This paper characterizes the optimal information structure in insurance markets in the presence of adverse selection. The optimal information structure minimizes ex-post risk subject to a participation constraint for insurees and a break-even constraint from insurers. In the unique optimal information structure, trade occurs with probability one and different risk-types are pooled together in the same signal. Surprisingly, these signals are not monotone so that low types are pooled with high types, while intermediate types are bundled together. We provide a simple algorithm that delivers the optimal information structure and derive comparative statics. We explore some applications and generalizations.

Keywords: Insurance Markets, Adverse Selection, Information Design

JEL Classification: D82, G22, I13