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This paper considers the design of an optimal unemployment insurance system. The problem is modeled as a repeated principal-agent problem involving a risk-averse agent--the unemployed worker--and a risk-neutral principal, which cannot montor the agent's search effort. The optimal long-term contract involves a replacement ratio that decreases throughout the unemployment spell and a wage tax after reemployment that, under some mild regularity conditions, increases with the lenght of the unemployment spell. Some numerical results suggest that the gains from switching to this optimal unemployment insurance scheme could be quite large. The performance of this optimal contract is also compared to alternative liquidity provision mechanisms. Copyright 1997 by the University of Chicago.