Optimal Insurance Trading: Full Insurance with Unfair Prices and Asymmetric Information

In this paper we analyze trading behaviour in an economy with substantial individual heterogeneity and individual agent- specific endowment risks. We establish that markets can be made effectively complete with a very small number of assets. In particular, if full insurance contracts are available, agents will only actively trade in two assets: a mutual fund and a bond. We also establish that contrary to standard results in the insurance demand literature, agents' optimal insurance demand can include in equilibrium full insurance in the presence of insurance prices which are actuarially unfair and that this demand will be independent of the correlation of insurance payments and the payments of other assets. Finally, we introduce asymmetric information concerning agents' risks into the economy and we show that adding a restriction on agents' possible insurance trades rather than introduce additional inefficiencies serves to ensure the attainability of efficient net trades.