Welfare-Improving Ambiguity in Insurance Markets with Asymmetric Information

Abstract

We consider a model of competitive insurance markets involving both asymmetric information and ambiguity about the accident probability. We show that there can exist a full-insurance pooling equilibrium. We also present an example where an increase in ambiguity leads to a strict Pareto improvement. Higher ambiguity relaxes the high-risks’ incentive compatibility constraint and allows low risks to buy more insurance. Higher ambiguity also deteriorates the low risks’ expected utility from holding an uncertain prospect. If the former effect dominates, the expected utility of low risks increases and given that the high risks’ utility remains unaffected, the increase in ambiguity implies a strict Pareto improvement.

Keywords: ambiguity aversion, asymmetric information, value of ambiguous information

JEL Classification: D82, G22