The Overcondence Problem in Insurance Markets

Adverse selection has long been recognized as a rationale for government intervention in insurance markets and for the adoption of public compulsory insurance. A di¤erent rationale for compulsory insurance is that overcon…dent individuals may underinsure because they underestimate the relevant risks. We show that government intervention is not a Pareto improvement in an adverse selection model with a signi…cant fraction of overcon…dent agents. We underline that behavioral biases need not be the basis for government intervention. In fact, behavioral biases may overturn existing compelling reasons for intervention in the economy. Our model also delivers novel positive implications on aggregate variables that have been at the center of recent empirical investigation. We thank Guillaume Frechette, Hide Hichimura, Ben Lockwood, Costas Meghir, Lars Nesheim and Jean Tirole for their comments. yKellogg School of Management, MEDS Department, 2001 Sheridan Rd., Evanston, IL 60208, USA. zDepartment of Economics, Gower Street, London WC1E 6BT, UK.