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 imp..