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

57 Pages Posted: 10 Jun 2018 Last revised: 15 May 2020

See all articles by Yuan-Mao Kao

Yuan-Mao Kao

Duke University - Fuqua School of Business

N. Bora Keskin

Duke University - Fuqua School of Business

Kevin Shang

Duke University

Date Written: May 13, 2020

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

Suggested Citation

Kao, Yuan-Mao and Keskin, N. Bora and Shang, Kevin, Impact of Information Asymmetry and Limited Production Capacity on Business Interruption Insurance (May 13, 2020). Available at SSRN: https://ssrn.com/abstract=3184530 or http://dx.doi.org/10.2139/ssrn.3184530

Yuan-Mao Kao

Duke University - Fuqua School of Business ( email )

Box 90120
Durham, NC 27708-0120
United States

N. Bora Keskin (Contact Author)

Duke University - Fuqua School of Business ( email )

100 Fuqua Drive
Durham, NC 27708-0120
United States

HOME PAGE: http://faculty.fuqua.duke.edu/~nk145/

Kevin Shang

Duke University ( email )

100 Fuqua Drive
Durham, NC 27708-0204
United States

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