The Insurance is the Lemon: Failing to Index Contracts

The Insurance is the Lemon: Failing to Index Contracts

By Barney Hartman-Glaser, Benjamin Hébert
October 3,2017Working Paper No. 3569

We introduce a model to explain the widespread failure to index contracts to aggregate indices, despite the apparent risk-sharing benefits of indexation. Our model features these benefits, but demonstrates that asymmetric information about the ability of indices to measure underlying aggregate states can lead to risk-sharing failures and non-indexation. Suppose that a borrower receives an offer from a lender that features higher repayments in “good” states, in exchange for lower repayments in “bad” states. To make such an offer, a lender must ask for higher average repayments, because the lender is exposed to these aggregate risks. The borrower, however, is concerned that she is paying something for nothing; if the index is a poor measure of the true aggregate state, the cost of this contract might exceed its benefits. We provide conditions under which this effect is strong enough to cause the borrower to reject this contract, and choose a conventional, non-contingent contract instead. Under these conditions, many equilibria are possible, and they can be Pareto-ranked; the use of non-contingent contracts can be viewed as a coordination failure.