Optimal Risk-sharing under Adverse Selection and Imperfect Risk Perception∗

The present paper thoroughly explores second-best efficient allocations in an insurance economy with adverse selection. We start with a natural extension of the classical model, assuming less than perfect risk perception. We characterize the constraints on efficient redistribution, and we summarize the incidence of incentive constraints on the economy with the notions of weak and strong adverse selection. Finally, we show in what sense improving risk perception enhances welfare.