The Strategic Role of Business Insurance

The use of business insurance has been traditionally studied in a single‐firm setting, but in reality preventing operational accidents involves the (unobservable) efforts of multiple firms. We show that, in a multifirm setting, insurance can be used strategically as a commitment mechanism to prevent excessive free riding by other firms. In the presence of wealth imbalances, contracts alone leave wealth‐constrained firms with inefficiently low incentives to exert effort (because of limited liability) and firms with sufficient wealth with excessive incentives. Insurance allows the latter to credibly commit to lower effort, thereby mitigating the incentives of the wealth‐constrained firms to free ride. This finding shows that insurance can improve the efficiency of risk management efforts by decreasing free‐riding problems. This paper was accepted by Yossi Aviv, operations management.