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

Yuan-Mao Kao (), N. Bora Keskin () and Kevin Shang ()
Additional contact information
Yuan-Mao Kao: Fuqua School of Business, Duke University, Durham, North Carolina 27708
N. Bora Keskin: Fuqua School of Business, Duke University, Durham, North Carolina 27708
Kevin Shang: Fuqua School of Business, Duke University, Durham, North Carolina 27708

Management Science, 2022, vol. 68, issue 4, 2824-2841

Abstract: We consider a firm that 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. Anticipating a higher premium, the low-demand firm 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- and low-demand contracts are affected by the firm’s operational characteristics in the same direction, and the informational characteristics impact those contracts differently. We also analyze the case in which 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 (search for similar items in EconPapers)
Date: 2022
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
http://dx.doi.org/10.1287/mnsc.2020.3776 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:68:y:2022:i:4:p:2824-2841

Access Statistics for this article

More articles in Management Science from INFORMS Contact information at EDIRC.
Bibliographic data for series maintained by Chris Asher ().