Optimism

Insurance and Perceptions: How to Screen Optimists and Pessimists
Johannes Spinnewijn London School of Economics March 17, 2010 PRELIMINARY. COMMENTS VERY WELCOME.

Abstract Individuals have di¤ering beliefs about risks they face and their ability to mitigate these risks. Pro…t-maximizing …rms screen identical agents with di¤erent beliefs by providing less insurance to optimists than to pessimists. Optimists perceive the risk to be less likely than pessimists given their respective choices of precautionary e¤orts. Depending on the nature of competition, the screening distortions in insurance coverage are determined by di¤erences in beliefs about the likelihood or the marginal return to e¤ort. I show that heterogeneity in beliefs strengthens the case for government intervention in insurance markets and can explain the negative correlation between risk occurrence and insurance coverage found in empirical studies. Keywords: Insurance Markets, Moral Hazard, Risk perceptions, Adverse Selection JEL Classi…cation Numbers: D80, G22, D60

Department of Economics, STICERD R515, LSE, Houghton Street, London WC2A 2AE, United Kingdom (email: j.spinnewijn@lse.ac.uk, web: http://personal.lse.ac.uk/spinnewi/). I would like to thank Arthur Campbell, Mathias Dewatripont, Peter Diamond, Florian Ederer, Bengt Holmström, Bruno Jullien, Frans Spinnewyn, Jean Tirole, Ivan Werning and participants at the MIT theory lunch seminar for helpful comments.

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Introduction

The perception of risk is inherently subjective.1 Financial traders disagree about the risk of investments, mortgage bankers about the risk of defaulting homeowners, homeowners and renters about the risk of ‡ ooding, old and young drivers about the risk of a car accident. One person may perceive a risk as very likely, while another may perceive the same risk as unlikely. At the same time, the perception of the extent to which precautionary e¤orts mitigate the risk may di¤er as well. Both the perception of...