Insurance Contracts under Beliefs Contamination

We propose an insurance model introducing a global contamination on agents' beliefs over exogenous and endogenous variables. We establish conditions for the elasticity of contamination such that insurance demand declines with an increase in the level of such contamination. Our model assumes that agents are risk averse and distort their beliefs about exogenous events. Distortion also influences expectations over insurance transfers by strategic default, and leads to a price markup in relation to its actuarilly fair level as markets select larger insurers, increasing their market power. We impose boundaries on the relation between risk aversion and the elasticity of contamination, which is robust in the sense that insurance demand will decline even when the beliefs contamination leads to an increase in the probability of large loss. We further show that contracts are not efficient, resulting in a long run welfare loss.