Consumer Risk Perceptions and Information in Insurance Markets with Adverse Selection

Abstract

Standard models of adverse selection in insurance markets assume policyholders know their loss distributions. This study examines the nature of equilibrium and the equilibrium value of information in competitive insurance markets where consumers lack complete information regarding their loss probabilities. We show that additional private information is privately and socially valuable. When the equilibrium policies separate types, policyholders can deduce the underlying probabilities from the contracts, so it is information on risk type, rather than loss probability per se, that is valuable. We show that the equilibrium is “as if” policyholders were endowed with complete knowledge if, and only if, information is noiseless and costless. If information is noisy, the equilibrium depends on policyholders' prior beliefs and the amount of noise in the information they acquire.