Contract design for equipment after-sales service with business interruption insurance

Abstract

After-sales service is strategically important for mission-critical equipment due to the high operational risks involved (e.g., machine breakdowns). To address this challenge, the operators of such equipment often purchase business interruption (BI) insurance to mitigate operational risks. In this paper, we develop a principal-agent model to study an after-sales service contracting problem with an insurance option. Two prevailing contract forms are considered: a resource-based contract (RBC) and a performance-based contract (PBC). We first show that, in the presence of insurance, a PBC outperforms an RBC in terms of system performance due to the skewed incentives inherent in an RBC. More important, our results show that insurance plays contrasting roles in incentivizing a service supplier under the two contracting mechanisms. Under an RBC, insurance improves the service supplier’s effort provision and hence benefits the operator because insurance provides a risk-sharing mechanism that better aligns the incentives of the service supplier and the operator. Under a PBC, although the supplier’s equilibrium effort remains at the first-best level regardless of the insurance coverage level, the use of insurance changes the operator’s optimal contract and the risk allocation between the operator and the supplier. Our findings provide important insights into the interplay of insurance and contract incentives in an after-sales service context.