Impact of Information Asymmetry and Limited Production Capacity on Business Interruption Insurance

Abstract

We consider a firm which faces a potential disruption in its normal operations can purchase business interruption (BI) insurance from an insurer to guard against the disruption risk. The firm makes demand forecasts, and can put a recovery effort if a disruption occurs; both are unobservable to the insurer. Accordingly, the insurer offers BI insurance to the firm while facing adverse selection and moral hazard. We first find that because of the joint effect of limited production capacity and self-impelled recovery effort, the firm with a lower demand forecast benefits more from BI insurance than that with a higher demand forecast, and has an incentive to pretend to have the higher demand forecast to obtain more profit. We then derive the optimal insurance contracts to deal with the information asymmetry, and show how the firm’s characteristics affect the optimal contracts. Both high-demand and low-demand contracts are affected by the firm’s operational characteristics in the same direction, while the informational characteristics impact those contracts differently. We also analyze the case where the firm can choose its initial capacity, and find that from the firm’s perspective, capacity and BI insurance could be either substitutes or complements.

Keywords: Business Interruption Insurance, Moral Hazard, Adverse Selection, Disruption Management