Managing Disruption Risk: The Interplay Between Operations and Insurance

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 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.

Exploring impact factors of shippers’ risk prevention activities: A European survey in transportation

“…Ojha et al (2013) show that logistics service providers apply measures to improve the integrity of logistics and transport processes. One central activity is the purchase of insurance coverage to absorb consequences of risks as transport disruptions (Wagner, 2008;Dong and Tomlin, 2012). This leads to the conclusion that the presence of a risk management system and recent risk management activities positively impact the willingness to apply prevention measures.…”

Severe Weather and Automobile Assembly Productivity

“…For example, a number of papers investigate sourcing strategies when suppliers have varying reliability (e.g. Tomlin (2006), Wang and Tomlin (2010), Dong and Tomlin (2012)). Some work investigates disruptions empirically (e.g., Hendricks and Singhal (2005)) but in none of these cases is a connection made between the disruption and severe weather.…”

Modelling Risk Coordination of Supply Chains with Put Option Contracts and Selective Return Policies

“…Lin et al demonstrated that insurance contracts are effective in achieving coordination of the supply chain [21], but the suppliers may incur an administrative cost in monitoring the retailer's sales situation. Dong and Tomlin studied risk management with business interruption insurance, they proved that insurance is never a substitute for operational measures and that insurance may lead to higher inventory investment and/or a larger benefit from emergency sourcing [22].…”