Publication Date: January 2019
I model ﬁnancial markets that structure decision-making into discrete points separating contract oﬀers, applications, and acceptance/denial decisions. Endogenous beliefs about applicants’ risk types emerge as the institutional process extracts private information allowing uninformed ﬁrms to infer risk qualities by comparing applications of many consumers. Endogenous beliefs and low-risk consumer behavior render truthful disclosure of transactions incentive compatible supporting a unique equilibrium robust to cream-skimming and cross-subsidizing deviations, even under Hellwig’s “secret” policy assumption. In equilibrium each type demands low-risk’s optimal pooling policy and high-risk supplement to full coverage at fair-price. Nonpassive consumers’ belief ﬁrms are sequentially rational necessary for equilibrium; lemon equilibrium with only high-risk insured possible.
Keywords: Adverse selection, Sequential rationality, Screening, Signaling, Incentive compatibility, Insurance pooling
JEL Classification Codes: D82, G22