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Managing Disruption Risk: The Interplay Between Operations and Insurance

Author

Listed:
  • Lingxiu Dong

    (Olin Business School, Washington University in St. Louis, St. Louis, Missouri 63130)

  • Brian Tomlin

    (Tuck School of Business at Dartmouth, Hanover, New Hampshire 03755)

Abstract

Disruptive events that halt production can have severe business consequences if not appropriately managed. Business interruption (BI) insurance offers firms a financial mechanism for managing their exposure to disruption risk. Firms can also avail of operational measures to manage the risk. In this paper, we explore the relationship between BI insurance and operational measures. We model a manufacturing firm that can purchase BI insurance, invest in inventory, and avail of emergency sourcing. Allowing the insurance premium to depend on the firm's insurance and operational decisions, we characterize the optimal insurance deductible and coverage limit as well as the optimal inventory level. We prove that insurance and operational measures are not always substitutes, and we establish conditions under which they can be complements; that is, insurance can increase the marginal value of inventory and can increase the overall value of emergency sourcing. We also find that the value of insurance is higher for those firms less able to absorb financially significant disruptions. As disruptions become longer but rarer, the value of emergency sourcing increases, and the value of inventory and the value of insurance increase before eventually decreasing. This paper was accepted by Martin Lariviere, operations management.

Suggested Citation

  • Lingxiu Dong & Brian Tomlin, 2012. "Managing Disruption Risk: The Interplay Between Operations and Insurance," Management Science, INFORMS, vol. 58(10), pages 1898-1915, October.
    • Handle: RePEc:inm:ormnsc:v:58:y:2012:i:10:p:1898-1915
    DOI: 10.1287/mnsc.1120.1524
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    References listed on IDEAS

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