Managing Disruption Risk: The Interplay between Operations and Insurance

Management Science, 58(10) 1898-1915

Tuck School of Business Working Paper No. 2609805

Posted: 24 May 2015

See all articles by Lingxiu Dong

Lingxiu Dong

Washington University in St. Louis - John M. Olin Business School

Brian Tomlin

Tuck School of Business at Dartmouth

Date Written: January 11, 2012

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.

Keywords: Disruptions; Inventory; Insurance

Suggested Citation

Dong, Lingxiu and Tomlin, Brian, Managing Disruption Risk: The Interplay between Operations and Insurance (January 11, 2012). Management Science, 58(10) 1898-1915; Tuck School of Business Working Paper No. 2609805. Available at SSRN: https://ssrn.com/abstract=2609805

Lingxiu Dong (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1156
St. Louis, MO 63130-4899
United States

Brian Tomlin

Tuck School of Business at Dartmouth ( email )

Hanover, NH 03755
United States

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