Misperceptions and Contract Distortions in Insurance Markets

Abstract

This paper extends the theory and empirics of selection markets to account for heterogenous
risk misperceptions and endogenous contracts. The literature has typically assumed zero or a
uniform bias across the population, and a fixed contract space. I first develop the theoretical
tools to analyze the equilibrium and welfare impact of risk misperceptions in a variety of market
structures and equilibrium concepts. The theory shows that a key statistic is the covariance
between risk and risk misperception in addition to the direction of misperception. Empirically, I
show that in mortality risk markets the long-lived are pessimistic, and the short-lived relatively
unbiased. I demonstrate the robustness of these findings to an accounting for elicitation error.
These results imply that the intensive margin, for example in annuity markets, is critically
important for welfare and particularly distorted with this pattern of misperception. The annuity
puzzle is clarified as an equilibrium distortion downwards of both the participation margin and
the insurance offered in the market.