A joint strategy based on ordering and insurance for mitigating the effects of supply chain disruption on risk-averse firms

Abstract

We examine the mitigation strategy for a risk-averse firm facing supply chain disruption threat under an all-or-nothing assumption. The firm orders from an upstream supplier to satisfy downstream stochastic demand, and mitigates the damage it suffers from disruption by adjusting its ordering decision and buying business interruption (BI) insurance. We explore the firm's joint ordering and insurance decisions in perfectly competitive and imperfectly competitive insurance markets, and demonstrate that BI insurance effectively reduces the losses caused by supply chain disruption and eliminates the effect of the firm's risk-averse attitude. In a perfectly competitive insurance market, the firm always purchases full insurance coverage; in an imperfectly competitive insurance market, the firm's ordering and insurance decisions are always complementary. We then extend our model to accommodate the firm's overconfidence behavior and partial damage, and conclude that overconfidence about risk probability has a negative effect on the firm's utility and our main conclusions still hold in situations of partial damage.