Asymmetric Information, Heterogeneity in Risk Perceptions and Insurance: An Explanation to a Puzzle

Abstract

Competitive models of asymmetric information predict a positive relationship between coverage and risk. In contrast, most recent empirical studies find either negative or zero correlation. This paper, by introducing heterogeneity in risk perceptions into an asymmetric information competitive model, provides an explanation to this puzzle. If optimism discourages precautionary effort, there exist separating equilibria exhibiting the observed empirical patterns. It is also shown that zero correlation is consistent with information barriers to trade in insurance markets. The predictions of our model allow us to empirically distinguish it from standard asymmetric information models.