The Insurance is the Lemon: Failing to Index Contracts

The Insurance is the Lemon: Failing to Index Contracts

By Barney Hartman-Glaser, Benjamin Hébert
December 29,2017Working Paper No. 3569

We model the widespread failure of contracts to share risk using available indices. A borrower and lender can share risk by conditioning repayments on an index. The lender has private information about the ability of this index to measure the true state the borrower would like to hedge. The lender is risk-averse, and thus requires a premium to insure the borrower. The borrower, however, might be paying something for nothing, if the index is a poor measure of the true state. We provide sufficient conditions for this effect to cause the borrower to choose a non-indexed contract instead.