Optimal Insurance Demand when Contract Nonperformance Risk is Perceived as Ambiguous

We study the optimal insurance demand of a riskand ambiguity-averse consumer if contract nonperformance risk is perceived as ambiguous. We find that the consumer’s optimal insurance demand is lower compared to a situation without ambiguity and that his degree of ambiguity aversion is negatively associated with the optimal level of coverage. We also determine sufficient conditions for biased beliefs or greater ambiguity to reduce the optimal demand for insurance and discuss wealth effects. Finally, we scrutinize several alternative model specifications to demonstrate the robustness of our main findings and discuss implications of our findings.