Managing Disruption Risk: The Interplay Between Operations and Insurance

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 establish conditions under which they can be complements; that is, insurance leads to a higher inventory investment and/or a larger benefit from emergency sourcing. We also find that the value of insurance is higher for those firms less able to absorb the post-disruption consequences of 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.