Biased perceptions of risks change the perceived value of insurance and the perceived
returns to avoiding these risks. I show empirically that unemployed workers overestimate
how quickly they will find work, but underestimate the return to their search efforts.
I analyze the consequences for the optimal design of unemployment insurance. With biased
beliefs, contracts equalizing the marginal smoothing benefit and the moral hazard cost
of insurance are suboptimal. Social and private insurance diverge; a paternalistic social
planner corrects the moral hazard cost for the distortion in the insured’s effort choice,
while private insurers focus on the perceived rather than the true smoothing benefits.
When unemployed workers are optimistic, privatizing unemployment insurance may result in
inefficiently low or rapidly decreasing unemployment benefits.