Insurance Demand and Heterogeneity in Risk Perception

We emphasize the role that non†linear probability transformation plays in determining the insurance choices under asymmetric information. In particular, we assume that agents are heterogeneous with respect to their attitudes to probabilities. For rare hazards, such probabilistic attitudes have significant impact on equilibrium. The key finding is that a sufficiently pessimistic agent always receives full insurance, irrespective of his exposure to risk. We also employ the non†linear probability weighting to explain the recent empirical puzzle regarding the correlation between ex†post risk and insurance coverage, according to which, this correlation is negative.