Do You Trust Your Insurer? Ambiguity About Contract Nonperformance and Optimal Insurance Demand

Article abstract: We study optimal insurance demand for a risk- and ambiguity-averse consumer under ambiguity about contract nonperformance. Ambiguity aversion lowers optimal insurance demand and the consumer’s degree of ambiguity aversion is negatively associated with the optimal level of coverage. A more pessimistic belief and greater ambiguity may increase or decrease the optimal demand for insurance, and we determine sufficient conditions for a negative effect. We also discuss wealth effects and evaluate the robustness of our results by considering several alternative models of ambiguity aversion. Our findings show how ambiguity about contract nonperformance can undermine the functioning of insurance markets, making it a concern for regulators. Caution is required though because demand reactions are only imperfectly informative about the welfare effects of ambiguity about contract nonperformance.